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A comment on the relationship between operating leverage and financial leverage

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  • Glover, Kristoffer

Abstract

Using a real options model, Sarkar (2020) recently demonstrated that operating and financial leverage are not necessarily substitutes. Once a firm is allowed to optimize their operating capacity (hence operating leverage), an increase in one could in fact lead to an increase in the other. Contrary to the claims made in Sarkar (2020), however, we demonstrate in this note that appealing to a firm’s capacity decision is not necessary to produce such results. Specifically, we show that if a firm’s embedded abandonment option is sufficiently valuable, the operating–financial leverage relationship can also become positive, irrespective of the firm’s operating choices.

Suggested Citation

  • Glover, Kristoffer, 2024. "A comment on the relationship between operating leverage and financial leverage," Finance Research Letters, Elsevier, vol. 67(PA).
    • Handle: RePEc:eee:finlet:v:67:y:2024:i:pa:s154461232400552x
    DOI: 10.1016/j.frl.2024.105522
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    References listed on IDEAS

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    More about this item

    Keywords

    Operating leverage; Financial leverage; Leverage substitution; Real options; Abandonment option; Default option;
    All these keywords.

    JEL classification:

    • G3 - Financial Economics - - Corporate Finance and Governance
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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