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

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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.

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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 329.

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Length: 23
Date of creation: 01 Apr 2013
Date of revision:
Handle: RePEc:uts:rpaper:329

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Keywords: Trade-off theory; operating leverage; ?nancial leverage; abandonment option;

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  1. Kane, Alex & Marcus, Alan J & McDonald, Robert L, 1984. " How Big Is the Tax Advantage to Debt?," Journal of Finance, American Finance Association, vol. 39(3), pages 841-53, July.
  2. Stewart C. Myers, 1984. "Capital Structure Puzzle," NBER Working Papers 1393, National Bureau of Economic Research, Inc.
  3. Nevins D. Baxter, 1967. "Leverage, Risk Of Ruin And The Cost Of Capital," Journal of Finance, American Finance Association, vol. 22(3), pages 395-403, 09.
  4. Titman, Sheridan & Wessels, Roberto, 1988. " The Determinants of Capital Structure Choice," Journal of Finance, American Finance Association, vol. 43(1), pages 1-19, March.
  5. Leland, Hayne E, 1994. " Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 49(4), pages 1213-52, September.
  6. Ivo Welch, 2004. "Capital Structure and Stock Returns," Journal of Political Economy, University of Chicago Press, vol. 112(1), pages 106-131, February.
  7. Alex Triantis & Adam Borison, 2001. "Real Options: State Of The Practice," Journal of Applied Corporate Finance, Morgan Stanley, vol. 14(2), pages 8-24.
  8. Raghuram G. Rajan & Luigi Zingales, 1994. "What Do We Know About Capital Structure? Some Evidence from International Data," NBER Working Papers 4875, National Bureau of Economic Research, Inc.
  9. Murray Z. Frank & Vidhan K. Goyal, 2009. "Capital Structure Decisions: Which Factors Are Reliably Important?," Financial Management, Financial Management Association International, vol. 38(1), pages 1-37, 03.
  10. Myers, Stewart C, 1984. " The Capital Structure Puzzle," Journal of Finance, American Finance Association, vol. 39(3), pages 575-92, July.
  11. Myers, Stewart C., 1984. "Capital structure puzzle," Working papers 1548-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  12. Sudipto Sarkar & Fernando Zapatero, 2003. "The Trade-off Model with Mean Reverting Earnings: Theory and Empirical Tests," Economic Journal, Royal Economic Society, vol. 113(490), pages 834-860, October.
  13. Kristoffer Glover & Gerhard Hambusch, 2012. "Leveraged Investments and Agency Conflicts When Prices Are Mean Reverting," Research Paper Series 314, Quantitative Finance Research Centre, University of Technology, Sydney.
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