A comment on the relationship between operating leverage and financial leverage

Kristoffer Glover

Finance Research Letters, 2024, vol. 67, issue PA

Abstract: Using a real options model, Sarkar (2020) recently demonstrated that operating and financial leverage are not necessarily substitutes. Once a firm is allowed to optimize their operating capacity (hence operating leverage), an increase in one could in fact lead to an increase in the other. Contrary to the claims made in Sarkar (2020), however, we demonstrate in this note that appealing to a firm’s capacity decision is not necessary to produce such results. Specifically, we show that if a firm’s embedded abandonment option is sufficiently valuable, the operating–financial leverage relationship can also become positive, irrespective of the firm’s operating choices.

Keywords: Operating leverage; Financial leverage; Leverage substitution; Real options; Abandonment option; Default option (search for similar items in EconPapers)
JEL-codes: G13 G3 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finlet:v:67:y:2024:i:pa:s154461232400552x

DOI: 10.1016/j.frl.2024.105522

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