Risk Perception

In the first place, the risk perceptions of personal and corporate leverage are different. If home made and corporate leverages are perfect substitutes, as the MM Approach the risk to which an investor is exposed, must be identical irrespective of whether the borrowed (corporate leverage) or the investor himself borrows proportionate to his share in the firms debt. If not they cannot be perfect substitutes and consequently the arbitrage process effective. The risk exposure to the investor is greater with personal leverage than with leverage. The liability of an investor is limited in corporate enterprises in the sense that to the extent of his proportionate shareholdings in case the company is forced to go into liquidation. The risk to which he is exposed, therefore, is limited to his relative holding. The liability of an individual borrower is, on the other hand, unlimited as even his personal property is used for payment to the creditors. The risk to the investor with personal borrowing is instance, Mr X liability (risk), when the firm has borrowed (levered firm) 31,250, that is, his 10 per cent share in firm I. If he were to borrow equal to his proportionate share the firm’s debt (Rs 50,000), his liability will be Rs 80,000. Thus, investments in a levered firm (corporate leverage) and in an unlevered firm (personal leverage) are not on an equal footing from the viewpoint of risks to the investors. Since investors can reasonably be expected to prefer an arrangement which, while giving the same return, ensures lower risk, the personal and corporate leverages cannot be perfect substitutes.

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