Cyberproblem

Applying the Hamada Equation - Quicken

We previously introduced the concept of the Capital Asset Pricing Model (CAPM). The CAPM, as developed by Harry Markowitz and William Sharpe, contends that all stocks have an element of market risk. This market risk is materialized in the form of beta, which is determined by the covariance of an asset's returns with the market returns divided by the variance of the market returns. We arrive at an asset beta by running a linear regression of an asset's returns against market returns. However, we have never really addressed the matter of what drives beta.

In 1969, Robert Hamada published his paper, "Portfolio Analysis, Market Equilibrium, and Corporation Finance," wherein he combined the traditional CAPM and the Modigliani and Miller capital structure theory to create what is now called the "Hamada equation." The Hamada equation seeks to illustrate how financial leverage (by increasing debt) increases a firm's risk, and by extension the firm's beta. In this cyberproblem, we will use the Hamada equation to determine how useful it is when used in practice. Recall from the chapter, the Hamada equation is:

ß_L,% = ß_U[1 + (1-T)(D/E)].

For this cyberproblem, you will need to access Quicken's web site at http://www.quicken.com.

1. Access Quicken's web site, and request a stock quote for Pfizer, Inc., whose stock symbol is PFE. When the quote appears, scroll down the page and look for "Fundamentals" on the left side of your screen. Click on that. Now, a large screen of data appears. First, record the 60-month beta for Pfizer. You should find the beta in the first section of the "Fundamentals" page, called "Price and Valuation." Next, scroll further down the "Fundamentals" page until you find the "Financial Strength" section. In this section, we see two kinds of debt-to-equity ratios: total debt-to-equity and long-term debt-to-equity. Since we are concerned with the long-term capital structure effects on beta, we will use the long-term debt-to-equity ratio. So, be sure to write that down, too.
   
   
2. From the "Fundamentals" page, request reports on the following companies: Merck & Co. (MRK), Heinz, HJ Co. (HNZ), Kellogg Co. (K), Dominion Resources Va (D), Duke Energy (DUK), Dow Chemical Co. (DOW), and DuPont (DD). Be sure to record the same information (the 60-month beta and the long-term debt-to-equity ratio) for these companies as we did for Pfizer, Inc. Notice, at this point we have two companies each from the chemical, food, electric utilities, and drug industries.
   
   
3. These data illustrate that those firms in different industries and even firms within the same industry have relatively different capital structures. Using the Hamada equation and data gathered in parts a and b, unlever the betas of these eight companies. For simplicity, assume the corporate tax rate is 40% for all of these companies.
   
   
4. Compare the unlevered betas of the firms within the same industry. Are they consistent? Do they tend to support or contradict the theory behind the Hamada equation?
   
   
5. Now repeat this process for a new set of companies. Unlever the betas for Norsk Hydro (NHY, chemical), Johnson & Johnson (JNJ, drug), General Mills (GIS, food), and FPL Group (FPL, electric utility).
   
   
6. Compare these firms' unlevered betas to their industry counterparts' unlevered betas calculated in part c. Do they seem consistent with your previous results? What conclusions can you make about using the Hamada equation in practice?