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The trade-off theory revisited: on the effect of operating leverage

Kristoffer J. Glover (Finance Discipline Group, University of Technology, Sydney, Broadway, Australia and Quantitative Finance Research Centre, University of Technology, Sydney, Broadway, Australia)
Gerhard Hambusch (Finance Discipline Group, University of Technology, Sydney, Broadway, Australia and Quantitative Finance Research Centre, University of Technology, Sydney, Broadway, Australia and Centre for Applied Macroeconomic Analysis, Australian National University, Canberra, Australia)

International Journal of Managerial Finance

ISSN: 1743-9132

Article publication date: 28 January 2014

4160

Abstract

Purpose

The purpose of this paper is to investigate the effect of operating leverage, and the subsequent abandonment option available to managers, on the relationship between corporate earnings and optimal financial leverage, thereby providing an alternative (rational) explanation for the observed negative relationship between these two quantities.

Design/methodology/approach

Working in a dynamic capital structure setting, where corporate earnings are modelled as an exogenous stochastic process, the paper explicitly adds fixed operating costs to the firm's value optimisation. This introduces a degree of operating leverage (DOL) and a non-zero value to the implicit abandonment option of the firm's manager. Solving for the firm's optimal timing and financing decisions the paper is able to derive the relationship between current corporate earnings and optimal financial leverage for a large class of earnings uncertainty assumptions. The theoretical implications are then tested empirically using a large selection of S&P 500 firms.

Findings

The analysis reveals that the manager's flexibility to abandon the project introduces nonlinearities into the valuation that are sufficient to reconcile the trade-off theory with the empirically observed negative earnings/financial leverage relationship. The paper further finds theoretical and empirical evidence of a positive relationship between operating and financial leverage.

Originality/value

Previous studies have used mean-reverting earnings as an explanation for the observed negative earnings/financial leverage relationship in a trade-off theory setting. The paper shows that the relationship does not need to be process specific. Instead, it is a direct result of the financial flexibility of managers.

Keywords

Acknowledgements

The authors acknowledge numerous discussions with their colleagues; in particular Lorenzo Casavecchia, Marco Navone, and Nahid Rahman. They also thank an anonymous referee for useful comments. The usual disclaimers apply.

Citation

J. Glover, K. and Hambusch, G. (2014), "The trade-off theory revisited: on the effect of operating leverage", International Journal of Managerial Finance, Vol. 10 No. 1, pp. 2-22. https://doi.org/10.1108/IJMF-03-2013-0034

Publisher

:

Emerald Group Publishing Limited

Copyright © 2014, Emerald Group Publishing Limited

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