A Note on Operating Leverage and Expected Rates of Return

15 Pages Posted: 11 Oct 2006

See all articles by Graeme Guthrie

Graeme Guthrie

Victoria University of Wellington - School of Economics & Finance

Date Written: November 23, 2006

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.

Keywords: expected rate of return, operating leverage, real options

JEL Classification: G31, D24

Suggested Citation

Guthrie, Graeme, A Note on Operating Leverage and Expected Rates of Return (November 23, 2006). Available at SSRN: https://ssrn.com/abstract=936323 or http://dx.doi.org/10.2139/ssrn.936323

Graeme Guthrie (Contact Author)

Victoria University of Wellington - School of Economics & Finance ( email )

P.O. Box 600
Wellington 6140
New Zealand
64 4 463 5763 (Phone)

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