The Trade-Off Theory Revisited: On the Effect of Operating Leverage

Abstract

This paper investigates the effect of operating leverage, and the subsequent abandonment option available to managers, on the relationship between corporate earnings and optimal financial leverage, thereby providing an alternative (rational) explanation for the observed negative relationship between these two quantities. Working in a dynamic capital structure setting, where corporate earnings are modelled as an exogenous stochastic process, we explicitly add fixed operating costs to the firm's value optimisation. This introduces a degree of operating leverage and a non-zero value to the implicit abandonment option of the firm's manager. Solving for the firm's optimal timing and financing decisions we are able to derive the relationship between current corporate earnings and optimal financial leverage for a large class of earnings uncertainty assumptions. The theoretical implications are then tested empirically using a large selection of S&P 500 firms. Our analysis reveals that the manager's flexibility to abandon the project introduces nonlinearities into the valuation that are sufficient to reconcile the trade-off theory with the empirically observed negative earnings/financial leverage relationship. We further find theoretical and empirical evidence of a positive relationship between operating and financial leverage. Previous studies have used mean-reverting earnings as an explanation for the observed negative earnings/financial leverage relationship in a trade-off theory setting. We show that the relationship does not need to be process specific. Instead, it is a direct result of the financial flexibility of managers.

Does operating leverage increase firm's profitability and bankruptcy risk? Evidence from China's entry into WTO

“…Alternatively, the study of Ho, Xu, and Yap (2004) finds the mixed negative and positive results for Operating LEV and Financial LEV, but they are unable to get significant results. Operating and Financial LEV links can be positive (Glover & Hambusch, 2014), but their positive or negative relationship depends on the firm preference for leverages (Sarkar, 2018). Moreover, Kumar and Yerramilli (2016) study indicate that the relationship between Operating LEV and Financial LEV has not been satisfactorily tied down yet.…”

“…Andersen, Barslund, Hansen, Harr, and Jensen (2014) indicate that China WTO accessions increase the demand for Chinese commodities from manufacturing firms. The studies show that Operating LEV rises the profitability and decreases the Financial LEV, in addition, it also increases bankruptcy risk (Chen et al, 2019; Glover & Hambusch, 2014). But up to the authors' best knowledge, no study finds the relationship between Operating LEV, profitability, Financial LEV and bankruptcy risk by considering the WTO.…”

Bond Indenture Consent Solicitations as a Debt Management Tool

“…For example, covenants may restrict a company's ability to pay dividends, to incur additional debt, to engage in transactions with a controlling shareholder or to achieve a more optimal operating leverage (Glover and Hambusch [5]; Kahan and Tuckman [4]). Yet, evidence suggests that most solicitations entail either tender or exchange offers and are ultimately successful in gaining bondholder approval.…”

Leveraged investments and agency conflicts when cash flows are mean reverting

“…The model can be generalized to a fairly large class of time-homogeneous diffusions which encompasses many well known processes used in modern finance, such as the GBM, CIR and CEV models (seeBlack and Scholes, 1973, Cox, Ingersoll, and Ross, 1985, Cox, 1975. More details are available from the authors upon request.6 The interested reader may refer toGlover and Hambusch (2014) where the alternative interpretation is made. 7 This type of commitment allows the equityholders to borrow, on pre-negotiated terms, at any time during the life of the commitment.…”