Describe “homemade leverage.”

Homemade leverage is investors’ method of substituting their own borrowing or lending for corporate borrowing. Investors who want more leverage than a company has taken on can buy the company’s stock on margin that is, borrow money from a broker and use the borrowed funds to pay for a portion of the stock in order to add to the corporate borrowing. Investors who want less leverage than the company has taken on can invest a portion of their funds in a risk-free investment to offset some of the corporate borrowing. MM argued that homemade leverage was a perfect substitute for corporate borrowing, given their assumptions. As a result, investors do not care how much debt any firm has since they can use homemade leverage to adjust their overall debt exposure to precisely reproduce the effect of any level of corporate debt on their returns and risk.

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