Corporate Borrowing and Homemade Leverage

Based on Tables 17.3 and 17.4 and Figure 17.1, Ms. Morris draws the following conclusions:

1. The effect of financial leverage depends on the company's EBIT. When EBIT is relatively high, leverage is beneficial.

2. Under the expected scenario, leverage increases the returns to shareholders, as measured by both ROE and EPS.

3. Shareholders are exposed to more risk under the proposed capital structure because the EPS and ROE are much more sensitive to changes in EBIT in this case.

4. Because of the impact that financial leverage has on both the expected return to stockholders and the riskiness of the stock, capital structure is an important consideration.

The first three of these conclusions are clearly correct. Does the last conclusion necessarily follow? Surprisingly, the answer is no. As we discuss next, the reason is that shareholders can adjust the amount of financial leverage by borrowing and lending on their own. This use of personal borrowing to alter the degree of financial leverage is called homemade leverage.

We will now illustrate that it actually makes no difference whether or not Trans Am adopts the proposed capital structure, because any stockholder who prefers the proposed capital structure can simply create it using homemade leverage. To begin, the first part of Table 17.5 shows what will happen to an investor who buys $2,000 worth of Trans Am stock if the proposed capital structure is adopted. This investor purchases 100 shares of stock. From Table 17.4, we know that EPS will be either $.50, $3, or $5.50, so the total earnings for 100 shares will be either $50, $300, or $550 under the proposed capital structure.

homemade leverage

The use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

17. Financial Leverage and Capital Structure Policy

© The McGraw-Hill Companies, 2002

PART SIX Cost of Capital and Long-Term Financial Policy

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