Operating Leverage, Profitability, and Capital Structure

Abstract

Operating leverage increases profitability and reduces optimal financial leverage. Thus, operating leverage generates a negative relation between profitability and financial leverage that is thought to be inconsistent with the trade-off theory but is commonly observed in the data. We demonstrate the effect of operating leverage on firms’ profitability and financial leverage, as well as on the empirical relation between profitability and financial leverage, by using China’s entry into the World Trade Organization in 2001 and its effect on the capital–labor ratio of U.S. firms.

The relationship between operating leverage and financial leverage

“…They study the relationship between operating leverage and financial leverage when both are endogenously chosen, and their main result (with the caveat that DOL = Q ) is that DOL and DFL may be substitutes or complements depending on the size of the marginal tax rate relative to the marginal financial distress cost. Their model's main drawback is that DOL is determined entirely by capacity and is not affected by operating cost, although operating cost is known to be an important determinant of DOL (Shrieves, ; Chen et al ., ). In Section (Modeling), we show how our model differs from the two models described above.…”

“…Two recent papers have examined theoretically the relationship between DOL and DFL – Chen et al . () and Kumar and Yerramilli (). These are most relevant to our model; hence, they are briefly discussed below.…”

“…Chen et al . () use a standard contingent‐claim model augmented by capacity choice, to explain the negative relationship between profitability and DFL. Their operating profit is given by ( xQ γ – fQ ), where x is a stochastic variable, Q is the productive capacity, γ (0 ≤ γ ≤ 1) is a parameter of decreasing returns to scale and f is fixed operating cost per unit of capacity.…”

“…The traditional ‘trade‐off’ or ‘leverage substitution’ explanation views DOL and DFL as substitutes, because both have the effect of ‘levering up’ or increasing the firm's fundamental business risk by imposing fixed liabilities (fixed operating costs for DOL and fixed coupon payments for DFL). A firm using more of one should then use less of the other; the theoretical literature therefore predicts a negative relationship between DOL and DFL (Chen et al ., ; Dotan and Ravid, ; Mihov, ; Van Horne, , etc.). Our paper contributes to the literature by showing that this substitution effect is not the sole explanation for the DOL‐DFL relationship, and there is an additional effect resulting from the firm's capacity decision (via the channel of shareholder‐bondholder agency problem); hence, the overall relationship is not always a negative one.…”

“…The relationship between degree of operating leverage (DOL) and degree of financial leverage (DFL) is of significant interest in corporate finance (Chen et al ., ; Dotan and Ravid, ; Kumar and Yerramilli, ; Mandelker and Rhee, , etc.). This is because the DOL‐DFL nexus involves some of the most important managerial decisions in corporate finance, such as investment (which impacts DOL), capital structure (which determines DFL) and risk management (both systematic risk and default risk are impacted by the two types of leverage) .…”