Fama's Ratio and the Effect of Operating Leverage on the Cost of Capital Under CAPM

David Johnstone

Abacus, 2020, vol. 56, issue 2, 268-287

Abstract: The firm's operating leverage is its ratio of fixed to variable costs. It is widely understood that production settings with higher fixed costs and lower variable costs are high risk. Well‐rehearsed CAPM arguments show how the firm's beta and cost of capital is higher when its proportion of fixed costs is higher. Importantly, that generalization holds under CAPM if expected total costs are constant and merely re‐apportioned between fixed and variable, but does not hold if expected total costs change. In actual business contexts, higher fixed costs are intended to bring lower unit variable costs and often lower expected total costs. Allowing for such efficiency gains, the firm's risk‐adjusted cost of capital might typically fall despite the higher operating leverage. Formal proof follows directly from the payoffs or ‘certainty equivalent’ expression of CAPM. The CAPM insights and new CAPM equations brought to light in this proof are surprising and useful.

Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

Downloads: (external link)
https://doi.org/10.1111/abac.12191

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:bla:abacus:v:56:y:2020:i:2:p:268-287

Ordering information: This journal article can be ordered from
http://www.blackwell ... bs.asp?ref=0001-3072

Access Statistics for this article

Abacus is currently edited by G.W. Dean and S. Jones

More articles in Abacus from Accounting Foundation, University of Sydney
Bibliographic data for series maintained by Wiley Content Delivery ().