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

22 Pages Posted: 16 Mar 2013

See all articles by Kristoffer J. Glover

Kristoffer J. Glover

University of Technology Sydney (UTS) - School of Finance and Economics; Financial Research Network (FIRN)

Gerhard Hambusch

University of Technology Sydney

Date Written: March 14, 2013

Abstract

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.

Keywords: Trade-off theory, abandonment option, financial leverage, operating leverage

JEL Classification: G32, G13, D21

Suggested Citation

Glover, Kristoffer J. and Hambusch, Gerhard, The Trade-Off Theory Revisited: On the Effect of Operating Leverage (March 14, 2013). Available at SSRN: https://ssrn.com/abstract=2230721 or http://dx.doi.org/10.2139/ssrn.2230721

Kristoffer J. Glover (Contact Author)

University of Technology Sydney (UTS) - School of Finance and Economics ( email )

Haymarket
Sydney, NSW 2007
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Gerhard Hambusch

University of Technology Sydney ( email )

14-28 Ultimo Road
Ultimo, NSW 2007
Australia
+61295147749 (Phone)

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