The Trade-off Theory Revisited: On the Effect of Operating Leverage

Kristoffer Glover and Gerhard Hambusch ()

No 329, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: This paper investigates 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. Working in a dynamic capital structure setting, where corporate earnings are modelled as an exogenous stochastic process, we explicitly add fixed operating costs to the firm's value optimisation. This introduces a degree of operating leverage 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 we are 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. Our 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. We further find theoretical and empirical evidence of a positive relationship between operating and financial leverage. Previous studies have used mean-reverting earnings as an explanation for the observed negative earnings/financial leverage relationship in a trade-off theory setting. We show that the relationship does not need to be process specific. Instead, it is a direct result of the financial flexibility of managers.

Keywords: Trade-off theory; operating leverage; financial leverage; abandonment option (search for similar items in EconPapers)
JEL-codes: D21 G13 G32 (search for similar items in EconPapers)
Pages: 23 pages
Date: 2013-04-01
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Published as: Glover, K. and Hambusch, G., 2014, "The Trade-off Theory Revisited: On the Effect of Operating Leverage", International Journal of Managerial Finance, 10(1), 2-22.

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https://www.uts.edu.au/sites/default/files/qfr-archive-03/QFR-rp329.pdf (application/pdf)

Related works:
Journal Article: The trade-off theory revisited: on the effect of operating leverage (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:uts:rpaper:329

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