A note on operating leverage and expected rates of return

Graeme Guthrie

Finance Research Letters, 2011, vol. 8, issue 2, 88-100

Abstract: Conventional wisdom, used to explain the value premium, is that greater operating leverage increases systematic risk and therefore leads to a higher expected rate of return earned by a firm's owners. This paper shows that the relationship between operating leverage and the expected return is actually non-monotonic when allowance is made for the option to abandon an unprofitable project: the expected return is an increasing function of operating leverage when the latter is low, but a decreasing function when it is high. This demonstrates the dangers in drawing inferences from models that ignore the flexibility embedded in typical investment projects.

Keywords: Expected; rate; of; return; Operating; leverage; Real; options (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (10)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finlet:v:8:y:2011:i:2:p:88-100

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