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Degree of free cash flow leverage

David Yecham Aharon (Departmant of Finance, Ono Academic College, Israel)
Yoram Kroll (Departmant of Finance, Ono Academic College, Israel and Ruppin Academic Center, Israel)
Sivan Riff (Departmant of Finance, Ono Academic College Israel and University of Haifa, Israel)

Review of Accounting and Finance

ISSN: 1475-7702

Article publication date: 15 July 2019

Issue publication date: 9 August 2019

Abstract

Purpose

This paper aims to forgo the conventional (degree of operating leverage) risk measure by replacing elasticity of operating profits with respect to output with elasticity of free cash flow (FCF) with respect to optimal output and by considering exogenous random demand shocks for the firm’s products as a source of risk.

Design/methodology/approach

The elasticity risk measure accounts for corporate taxes and the cost of bankruptcy. The methodology is selecting optimal level of production investment and capital structure to generate efficient frontier of expected FCF and its risk in terms of its elasticity with respect to output.

Findings

The risk measure leads to efficient frontier between expected FCF and its idiosyncratic managerial risk. The model also resolves the empirical debate on the tradeoff between operating and financial leverages.

Originality/value

It is the first elasticity risk measure that embodied the impact of future level of capital expenditure, total level of assets and their sensitivity to random shocks in the product market.

Keywords

Citation

Aharon, D.Y., Kroll, Y. and Riff, S. (2019), "Degree of free cash flow leverage", Review of Accounting and Finance, Vol. 18 No. 3, pp. 346-365. https://doi.org/10.1108/RAF-03-2018-0061

Publisher

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Emerald Publishing Limited

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