A Note on Operating Leverage and Expected Rates of Return

Abstract:     
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, D24

working papers series