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Inter‐industry differences and the impact of operating and financial leverages on equity risk

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  • Ali F. Darrat
  • Tarun K. Mukherjee

Abstract

Based on the traditional assumption that the degree of combined leverage is strictly a product of operating and financial leverages (DOL and DFL), Mandelker and Rhee (1984) develop an interesting beta decomposition model. Two testable implications of their model, which apply to all firms, are that: (1) changes in DOL and/or DFL should exert a positive impact upon beta; and (2) a negative relationship should hold between DOL and DFL. Huffman (1983), however, questions this multiplicity assumption and, by arguing that a firm's capacity decision is endogenous, posits that an interaction prevails between a firm's DOL and DFL. An implication of Huffman's model is that the relationship between DOL, DFL, and beta depends on a firm's capacity decision and, therefore, may vary across industries. By employing a vector‐autoregressive causality approach, this study finds some evidence in support of Huffman's position.

Suggested Citation

  • Ali F. Darrat & Tarun K. Mukherjee, 1995. "Inter‐industry differences and the impact of operating and financial leverages on equity risk," Review of Financial Economics, John Wiley & Sons, vol. 4(2), pages 141-155, March.
    • Handle: RePEc:wly:revfec:v:4:y:1995:i:2:p:141-155
    DOI: 10.1016/1058-3300(95)90003-9
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