What Is Homemade Leverage?
Homemade leverage is used by an individual investor to artificially adjust the leverage of a company. An individual investing in a company with no leverage can recreate the effect of leverage using homemade leverage, which includes taking out personal loans on the investment. However, differences in the tax rate between the corporation and the individual will likely disrupt the ability of the investor to construct the leveraging scenario accurately.
- Individuals can use homemade leverage to recreate the effects of corporate leverage.
- The tax rate difference between corporations and individuals make replicating corporate leverage difficult, however.
- The Modigliani-Miller theorem states that a company’s capital structure should not affect its stock price because investors can use homemade leverage.
How Homemade Leverage Works
The use of leverage increases the potential for returns while increasing the riskiness of an investment. Companies that utilize leverage may be able to generate a more substantial return for shareholders, all else equal, than a company that does not employ leverage. However, investment in leveraged companies may be riskier than investment in companies that do not borrow.
A way to attempt to get around this risk/reward tradeoff is for an investor to buy shares of a company that does not utilize leverage and then takes out personal loans to gain personal leverage. Theoretically, if the person can borrow at the same rate as the company, the investor can earn a rate of return closer to a leveraged company return while being invested in a non-leveraged company.
The goal of the investor is to replicate the return compounding effects of corporate leverage synthetically but while being invested in a non-leveraged firm. Theoretically, an investor may be able to come close to this goal if they can borrow at the same rate the company is able to borrow.
The principle behind homemade leverage, described by the Modigliani-Miller theorem, is that investors do not care about capital structure, because they can undo any changes with their own homemade leverage. Thus, the capital structure of a company should not affect the stock price.
The Modigliani-Miller theorem says that investors have no regard for how a company finances its investments (debt versus equity) or pays its dividends. That’s because investors can mirror leverage in their own personal portfolio. However, the theorem also assumes that this holds true only if taxes and bankruptcy costs are absent and the market is efficient.
Advantages and Disadvantages of Homemade Leverage
Homemade leverage is meant to allow an investor to invest in an unlevered company to replicate the return of a levered firm. Taxes, however, make creating the exact leverage effect difficult, as the cost of corporate leverage and the cost of individual leverage differ.
Homemade leverage does, however, allow an investor to undo changes to a company’s capital structure that they do not agree with. For example, if a company that an investor owns shares in decides to raise capital via debt. A company can adjust their personal portfolio leverage to maintain the desired leverage.