Question

With ______ ______, an investor is able to replicate a corporation's capital structure by borrowing funds and using those funds along with their own money to buy the company's stock.
a) personal leverage
b) defensive leverage
c) personal borrowing
d) home made leverage
e) defensive borrowing

Answer 1

Answer:

D. Home made Leverage

Explanation:

Home made leverage is a situation in which an investor utilizes borrowed funds to artificially adjust or change the level of leverage of a company. An Home made leverage can be used to turn an unleveraged company to a leveraged one.

One of the terms of home made leverages, however, is that, the investor who is borrowing to make a company leveraged must be able to borrow at the same borrowing cost of the firm.

Reason for Using Home Made Leverage

One of the main reasons is as stated in the question, which is to replicate a corporation's capital structure.

According to  Modigliani-Miller theorem, however, the home made leverage will only work smoothly for an investor as long as taxes and bankruptcy costs are absent and the market is efficient. This clause is the reason for the initial clause that home mode leverage works as long as the investor is able to borrow at the same borrowing cost as the firm.