What Is Homemade Leverage?
Let me explain homemade leverage to you directly: it's a method I, as an individual investor, can use to artificially adjust the leverage of a company I'm investing in. If you're putting money into a company that has no leverage, you can recreate that leverage effect through homemade leverage by taking out personal loans on your investment. However, keep in mind that differences in tax rates between the corporation and you as an individual will likely make it hard to construct this leveraging scenario accurately.
Key Takeaways
- You as an individual can use homemade leverage to recreate the effects of corporate leverage.
- The tax rate difference between corporations and individuals makes 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
Understand that using leverage boosts the potential for returns but also ramps up the risk in your investment. Companies that use leverage might deliver bigger returns to shareholders than those that don't, assuming everything else is equal. Still, investing in leveraged companies can be riskier than in those that avoid borrowing.
Here's a way you can try to navigate this risk/reward balance: buy shares in a company without leverage and then take out personal loans to create your own leverage. In theory, if you can borrow at the same rate as a company would, you could achieve returns similar to those of a leveraged company while staying invested in a non-leveraged one.
Your goal here is to synthetically replicate the return-compounding effects of corporate leverage, all while being invested in an unlevered firm. Theoretically, you might get close to this if you can borrow at the company's rate.
Special Considerations
The core idea behind homemade leverage, as outlined in the Modigliani-Miller theorem, is that you, the investor, shouldn't care about a company's capital structure because you can undo any changes with your own homemade leverage. Therefore, the company's capital structure shouldn't influence its stock price.
The Modigliani-Miller theorem holds that investors are indifferent to how a company finances its investments—whether through debt or equity—or how it pays dividends, since you can mirror that leverage in your personal portfolio. But remember, this theorem assumes no taxes, no bankruptcy costs, and an efficient market.
Advantages and Disadvantages of Homemade Leverage
Homemade leverage is designed to let you invest in an unlevered company and replicate the returns of a levered one. However, taxes complicate creating the exact leverage effect, because the costs of corporate and individual leverage differ.
On the positive side, homemade leverage gives you the ability to undo changes in a company's capital structure that you disagree with. For instance, if a company you own shares in decides to raise capital through debt, you can adjust your personal portfolio leverage to keep your desired level.
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