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A note on operating leverage and expected rates of return

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  • Guthrie, Graeme

Abstract

Conventional wisdom, used to explain the value premium, 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 return is actually non-monotonic when allowance is made for the option to abandon an unprofitable project: the expected return is an increasing function of operating leverage when the latter is low, but a decreasing function when it is high. This demonstrates the dangers in drawing inferences from models that ignore the flexibility embedded in typical investment projects.

Suggested Citation

  • Guthrie, Graeme, 2011. "A note on operating leverage and expected rates of return," Finance Research Letters, Elsevier, vol. 8(2), pages 88-100, June.
    • Handle: RePEc:eee:finlet:v:8:y:2011:i:2:p:88-100
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    References listed on IDEAS

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    Cited by:

    1. Guthrie, Graeme, 2013. "A value premium without operating leverage," Finance Research Letters, Elsevier, vol. 10(1), pages 1-11.
    2. Luis García‐Feijóo & Benjamin A. Jansen, 2023. "International evidence on the association of leverage with stock returns and the value premium," The Financial Review, Eastern Finance Association, vol. 58(2), pages 315-341, May.
    3. Ho, Tuan & Kim, Kirak & Li, Yang & Xu, Fangming, 2023. "Can Real Options Explain the Skewness of Stock Returns?," Journal of Banking & Finance, Elsevier, vol. 148(C).
    4. Lifeng Gu & Dirk Hackbarth & Tim Johnson, 2018. "Inflexibility and Stock Returns," The Review of Financial Studies, Society for Financial Studies, vol. 31(1), pages 278-321.
    5. Ho, Tuan & Kim, Kirak & Li, Yang & Xu, Fangming, 2023. "Does real flexibility help firms navigate the COVID-19 pandemic?," The British Accounting Review, Elsevier, vol. 55(4).
    6. Graeme Guthrie, 2014. "Real Options And The Cross-Section Of Expected Stock Returns," Journal of Economic Surveys, Wiley Blackwell, vol. 28(2), pages 265-283, April.
    7. Huynh, Nhan, 2023. "Unemployment beta and the cross-section of stock returns: Evidence from Australia," International Review of Financial Analysis, Elsevier, vol. 86(C).
    8. Sarkar, Sudipto, 2018. "Optimal DOL (degree of operating leverage) with investment and production flexibility," International Journal of Production Economics, Elsevier, vol. 202(C), pages 172-181.
    9. Sudipto Sarkar, 2020. "The relationship between operating leverage and financial leverage," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 60(S1), pages 805-826, April.

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