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



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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  • Kristoffer Glover & Gerhard Hambusch, 2013. "The Trade-off Theory Revisited: On the Effect of Operating Leverage," Research Paper Series 329, Quantitative Finance Research Centre, University of Technology, Sydney.
  • Handle: RePEc:uts:rpaper:329

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    References listed on IDEAS

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    9. 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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    Cited by:

    1. Jamie A. Anderson-Parson & Terrill R. Keasler & Robin T. Byerly, 2015. "Bond Indenture Consent Solicitations as a Debt Management Tool," International Journal of Financial Studies, MDPI, Open Access Journal, vol. 3(3), pages 1-14, July.
    2. 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, vol. 12(1), pages 4-24, February.
    3. Correia, Ricardo & Población, Javier, 2015. "A structural model with Explicit Distress," Journal of Banking & Finance, Elsevier, vol. 58(C), pages 112-130.
    4. 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.

    More about this item


    Trade-off theory; operating leverage; financial leverage; abandonment option;

    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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