A note on operating leverage and expected rates of return
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.
Year of publication: |
2011
|
---|---|
Authors: | Guthrie, Graeme |
Published in: |
Finance Research Letters. - Elsevier, ISSN 1544-6123. - Vol. 8.2011, 2, p. 88-100
|
Publisher: |
Elsevier |
Keywords: | Expected rate of return Operating leverage Real options |
Saved in:
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