Homemade Leverage

In the world of finance, leverage means using either fixed cost assets or fixed cost funds. When fixed cost assets are used, the resulting leverage is called the operating leverage and when fixed cost funds are used, we have financial leverage.

We will refer to financial leverage in this post, which is created when a firm (or a person) uses borrowed funds (debt).

Homemade means something personal. Therefore, homemade leverage means personal leverage. Just like when companies borrow and create corporate leverage, individuals, when they borrow on their personal account, create homemade leverage.

Of course, a company can reduce its leverage by retiring some of its debt. Likewise, individuals can undo  the effect of corporate leverage (at least for themselves) by doing the exact opposite of borrowing, that is lending, which practically means investing in an interest bearing security.

The concept of homemade leverage emanates from the Miller and Modigilani propositions on capital structure, where they demonstrate that investors can substitute homemade leverage for corporate leverage, when they move from one firm to another to ensure that their return and risk exposure remains unchanged.

In an ideal world, investors can render the capital structure policy of a firm irrelevant through homemade leverage because they can create their own desired leverage status independent of what the company does.

However, we live in a world that is not perfect or ideal by any means. One of the major assumptions for homemade leverage to work is that individual investors can borrow and lend at the same rate of interest as corporations. We know that this is not possible. Also, the taxation rates applicable to corporate and personal incomes are different. With these imperfections entering in, the mechanism does not work as well as it is presented in theory.

Nevertheless, it should be kept in mind that the motivation for the homemade leverage argument is not to give us some unrealistic ideas but to suggest that the capital structure policy of a company on its own can not have any effect on its value. It is only when the market imperfections appear on the scene, the  capital structure policy of a firm starts making a difference to its value.

In order to impact the value, the corporate policy on how it finances it business must be something that can not be mimicked by individual investors for financing their personal investment in the company. If individual investors can undo the effect of corporate policy by their own actions, it loses relevance. As I said before, in real world, many imperfections enter the picture, preventing individual investors in imitating corporate leverage. If they are to do that, they can only do so at different borrowing and lending terms.

In this post, we are going to assume an ideal world, not because it exists, but because we wish to see if corporate leverage is potent enough on its own to affect a firm's value.  Or is it that the existence of an imperfect world makes the capital structure policy relevant. The underpinning is that if in an ideal world, investors can switch between companies and policies on their own without changing their risk - return profile, capital structure (the mix of debt and equity capital) would then be an irrelevant item on and of its own.

The following two videos explain how the mechanism of homemade leverage works in an ideal world. In the first video, we assume an investor who wants to move from a levered firm to an un - levered firm and in the second one, we look at the opposite case, where an investor wants to move from an un - levered to a levered firm without affecting his / her return, risk and proportional ownership in companies.

Moving from a Levered to an Un - levered firm:

Moving from an Un - Levered to a Levered firm: