The Effect of Agency Problems on Optimal Operating Leverage and Risk Allocation

25 Pages Posted: 24 Nov 2013

Date Written: November 20, 2013

Abstract

Prior research has established that high operating leverage leads to high systematic risk. We examine a firm's choice of operating leverage in a principal-agent setting, and find that the degree of operating leverage is strictly lower when the manager's actions are unobservable. Further, the production output is also lower when agency problems are present. The suboptimal operational decisions result in not only decreased shareholder value, but also lower consumer surplus and lower total social welfare. However, accounting information can help mitigate this problem. Specifically, the more precise the accounting information, the less the reduction in the players' payoffs. With the recent trend in risk management moving toward a more comprehensive approach in evaluating a firm's risk, the results of this paper can provide some insight on how risk affects a firm's stakeholders differently, and what consequences it has in a broader economic sense.

Suggested Citation

Chen, Hui, The Effect of Agency Problems on Optimal Operating Leverage and Risk Allocation (November 20, 2013). Available at SSRN: https://ssrn.com/abstract=2358670 or http://dx.doi.org/10.2139/ssrn.2358670

Hui Chen (Contact Author)

University of Zurich ( email )

Plattenstrasse 14
Zurich, CH-8032
Switzerland

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