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The trade-off theory revisited: on the effect of operating leverage

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  • Kristoffer J. Glover
  • Gerhard Hambusch

Abstract

Purpose - – The purpose of this paper is to investigate 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. Design/methodology/approach - – Working in a dynamic capital structure setting, where corporate earnings are modelled as an exogenous stochastic process, the paper explicitly adds fixed operating costs to the firm's value optimisation. This introduces a degree of operating leverage (DOL) 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 the paper is 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. Findings - – The 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. The paper further finds theoretical and empirical evidence of a positive relationship between operating and financial leverage. Originality/value - – Previous studies have used mean-reverting earnings as an explanation for the observed negative earnings/financial leverage relationship in a trade-off theory setting. The paper shows that the relationship does not need to be process specific. Instead, it is a direct result of the financial flexibility of managers.

Suggested Citation

  • Kristoffer J. Glover & Gerhard Hambusch, 2014. "The trade-off theory revisited: on the effect of operating leverage," International Journal of Managerial Finance, Emerald Group Publishing Limited, vol. 10(1), pages 2-22, January.
    • Handle: RePEc:eme:ijmfpp:v:10:y:2014:i:1:p:2-22
    DOI: 10.1108/IJMF-03-2013-0034
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    Cited by:

    1. Maya Sari, 2019. "Firm Size as Moderator to Capital Structure-Its Determinants Relations," GATR Journals jfbr163, Global Academy of Training and Research (GATR) Enterprise.
    2. Jamie A. Anderson-Parson & Terrill R. Keasler & Robin T. Byerly, 2015. "Bond Indenture Consent Solicitations as a Debt Management Tool," IJFS, MDPI, vol. 3(3), pages 1-14, July.
    3. Marco A. Paganini, 2021. "The DOL-DFL Nexus: The Relationship between the Degree of Operating Leverage (DOL) and the Degree of Financial Leverage (DFL)," International Journal of Economics and Finance, Canadian Center of Science and Education, vol. 13(6), pages 1-71, June.
    4. Qizhi Tao & Zohaib Zahid & Azhar Mughal & Farrukh Shahzad, 2022. "Does operating leverage increase firm's profitability and bankruptcy risk? Evidence from China's entry into WTO," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 27(4), pages 4705-4721, October.
    5. Irene Wei Kiong Ting & Hooi Hooi Lean & Qian Long Kweh & Noor Azlinna Azizan, 2016. "Managerial overconfidence, government intervention and corporate financing decision," International Journal of Managerial Finance, Emerald Group Publishing Limited, vol. 12(1), pages 4-24, February.
    6. Correia, Ricardo & Población, Javier, 2015. "A structural model with Explicit Distress," Journal of Banking & Finance, Elsevier, vol. 58(C), pages 112-130.
    7. Glover, Kristoffer J. & Hambusch, Gerhard, 2016. "Leveraged investments and agency conflicts when cash flows are mean reverting," Journal of Economic Dynamics and Control, Elsevier, vol. 67(C), pages 1-21.
    8. Correia, Ricardo & Dubiel-Teleszynski, Tomasz & Población, Javier, 2019. "Anticipating individual bank rescues," Economic Modelling, Elsevier, vol. 82(C), pages 345-360.
    9. Kanika Sachdeva & Abhishek Agarwal, 2023. "Factor influencing leveraging decision of Indian companies: evidence from panel data analysis," International Journal of Business and Globalisation, Inderscience Enterprises Ltd, vol. 35(1/2), pages 134-146.
    10. Benter Omollo Achieng & Willy Muturi & Joshua Wanjare, 2018. "Effect of Equity Financing Options on Financial Performance of Non-Financial Firms Listed at the Nairobi Securities Exchange, Kenya," Applied Economics and Finance, Redfame publishing, vol. 5(4), pages 160-173, July.
    11. Almanaseer Sufian, 2024. "The Impact of Equity Financing on Financial Performance: Evidence from Jordan," Foundations of Management, Sciendo, vol. 16(1), pages 157-176.

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    More about this item

    Keywords

    Abandonment option; Financial leverage; Operating leverage; Trade-off theory;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory

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