A Note on Operating Leverage and Expected Rates of Return
Victoria University of Wellington - School of Economics & Finance
November 23, 2006
Conventional wisdom, repeated in standard corporate finance texts, is that greater operating leverage increases systematic risk and therefore leads to a higher expected rate of return earned by a firm's owners. This paper shows that the relationship between operating leverage and the expected rate of return is actually non-monotonic when allowance is made for the real option to abandon an unprofitable project: the expected rate of return is an increasing function of operating leverage when the latter is low, but a decreasing function when it is high. This paper demonstrates the dangers in drawing inferences from static financial models or, more specifically, those that ignore the flexibility that is embedded in typical investment projects. It shows that when these real options are considered, supposedly 'standard' results can be overturned.
Number of Pages in PDF File: 15
Keywords: expected rate of return, operating leverage, real options
JEL Classification: G31, D24working papers series
Date posted: October 11, 2006
© 2013 Social Science Electronic Publishing, Inc. All Rights Reserved.
This page was processed by apollo5 in 0.344 seconds