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 special considerationsthe 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 leveragehomemade 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 