Homemade Leverage

Homemade leverage is the use of borrowing or lending to alter financial leverage of the company the investor is exposed to (Bhatnagar, 2009). The MM proposition demonstrates that if investors prefer an alternative capital structure different to the chosen leverage of the firm, investors may achieve same results by homemade leverage (Wilkinson, 2003).

We will now illustrate that a firm’s capital structure choice becomes irrelevant as any investor who favours the proposed capital structure can simply create it using homemade leverage model (Berk, 2011:455-458). For example, an investor who prefers to hold levered equity as opposed to the wholly equity firm can do so by adding leverage onto his portfolio i.e. buying stock on margin.

	Recession	Initial cost	Expansion
Unlevered equity	$900	$1000	$1400
Margin loan	(£525)	($500)	($525)
Levered equity	$375	$500	$875

While the cash flows of the unlevered equity serve as a security for the margin loan, the loan becomes risk free and investors may borrow at 5% risk free rate. The investor is able to replicate the payoffs to the levered equity using homemade leverage as illustrated in the table above for a cost of $500. Thus, by the Law of One Price, the levered equity must be valued at $500.

Supposing that the entrepreneur of the unlevered firm introduces debt, but the investor prefers to hold unlevered equity. The investor can replicate the payoffs of the unlevered equity by purchasing both of the firm’s debt and equity. Combining the cash flows of both stocks produces cash flows identical to unlevered equity ($1000) as illustrated below.

	Recession	Initial cost	Expansion
Debt	$525	$500	$525
Levered equity	$375	$500	$875
Unlevered equity	$900	$1000	$1400

In this scenario, a firm’s capital structure choice becomes irrelevant in respect of homemade leverage. However, under perfect market assumptions, different choices of capital structure offer no advantage to investors as they do not affect the firm’s value.