6885-15-9Q AID: 63238 | 21/05/2020

A company can either have an All-Equity structure or Debt-Equity structure. The value of the
company is equal to Value of Debt and Value of its equity. A public held company raises
funds through issue of Commercial Papers, Non-Convertible Debentures and Preferential and
Common Allotment of Equity. A privately held company is backed by Venture Capitalists,
Private Equity Funds and promoter holdings.

The concept of homemade leverage was first introduced by Modigliani and Miller. A rational
investor can increase or reduce his own leverage no matter what a firm’s capital structure is,
by taking personal loans from the investment, thus creating their own Homemade leverage.
The CAPM, Sharpe Ratio and M&M Propositions are based on this assumption.

Scenario 1: Creating Unlevered position in a firm

(a) Assuming, the firm is an All-equity firm. The investor can buy the company’s equity. This
will generate cash flows in the form of dividend.
(b) Now if the company switches to 40% debt structure, then the investor must invest 40% of
the cash into debt resulting in interest payment to the investor. Now, the net cash flow
generated by the investor is interest payment and dividend payment

Scenario 2: Creating a Levered position in a firm

(a) Assuming, the firm is an All-equity firm. The investor can buy the company’s equity with
borrowed capital. In this case, the investor has financed in firm’s equity with a mixture of
debt and equity.
(b) Now if the company switches to 40% debt structure, then the investor can buy firm’s
stock with own money.

To conclude, investors are indifferent towards firm’s capital structure. A rational investor
generally uses his own techniques to manage risk and increase rewards.