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On the Association between Operating Leverage and Risk

Published online by Cambridge University Press:  19 October 2009

Baruch Lev
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Extract

A link between the firm's operating decisions and the riskiness of its stocks was established. Differences in the production process affecting the relative shares of fixed and variable costs (i.e., the operating leverage) were found, both analytically and empirically, to be associated with risk differentials. Specifically, other things equal, the higher the operating leverage (i.e., the lower the unit variable costs) the larger the overall and systematic risk of the stocks.

Various practical implications are suggested by these findings. On the firm level, it can be expected that large capital expenditures associated with an operating leverage increase will increase stock riskiness. In these cases, the cut-off rate used for the capital budgeting decision (i.e., the cost of capital) should allow for the increased risk. The use of the current cost of capital as the cut-off rate would probably result in a decrease in stock prices, adversely affecting stockholders' wealth. On the investor level, these findings might assist in the estimation of common stocks' risk given expected changes in the firm's operating leverage. Specifically, they suggest that, if a firm will experience a significant operating leverage change, the estimation of risk measures based exclusively on historical returns would be inappropriate.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 9 , Issue 4 , September 1974 , pp. 627 - 641
Copyright
Copyright © School of Business Administration, University of Washington 1974

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References

1 Hamada, R. S., “The Effect of the Firm's Capital Structure on the Systematic Risk of Common Stocks,” Journal of Finance, vol. 27 (May 1972), pp. 437–438CrossRefGoogle Scholar. More on the relationship between earnings and returns for growth companies in Fama, E. F. and Miller, M. H., The Theory of Finance (New York: Holt, Rinehart and Winston, 1972), pp. 96–97.Google Scholar

2 The fixed costs element Fjt is, of course, also a random variable, but it is independent of demand, Qjt.

3 This assumes, of course, that in equilibrium the averate product price is identical for all firms in the industry, an assumption which seems tenable for a homogeneous and competitive industry.

4 The covariance of the fixed costs, Fjt, with the market portfolio return, rmt, is, of course, equal to zero.

5 Diamond, P. A., “The Role of a Stock Market in a General Equilibrium Model with Technological Uncertainty,” American Economic Review, vol. 57 (September 1967), pp. 759–776, especially p. 767.Google Scholar

6 This equivalence is also shown to be analogous to the Modigliani-Miller propositions that the total value of the firm is independent of the debt-equity mix.

7 See Appendix for complete sample listing.

8 This again is analogous to the industry homogeneity requirement in cost-of-capital studies (e.g., Miller, M. H. and Modigliani, F., “Some Estimates of the Cost of Capital to the Electric Utility Industry,” American Economic Review, vol. 56 (June 1966), pp. 334–391)Google Scholar, set to meet the equivalent risk-class assumption.

9 A few firms with incomplete data series were omitted.

10 For electric utilities also producing gas, a second independent variable, Q(G)jt, measuring gas output, was incorporated into (11).

11 In empirical studies dealing with cost behavior and production function determination, firms' costs are usually deflated by price indexes in order to concentrate on real values. This procedure was felt to be inappropriate here since the volatility of return measures, with which the variable costs are to be associated, are based on nominal values (i.e., nominal dividends and capital gains).

12 This estimation procedure assumes, of course, that the ex post determined β values are unbiased estimates of the “true” systematic risk.

13 The above regressions were also run with the size of the firm (measured by total sales) as an additional independent variable. This was done since size might be related to operation leverage and also to risk. However, the addition of the size variable did not significantly change the estimates reported in Tables 2 and 3.