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FINANCIAL LEVERAGES
AND INTRINSIC BUSINESS RISK ON FIRM VALUE
By
Fathi Abid
Modesfi
Professor of finance at university of Sfax
Fathi.Abid@fsegs.rnu.tn
And
Slim Mseddi
Modesfi
Assistant professor of finance at university of Sfax
Slim.Mseddi@fsegs.rnu.tn
1
THE IMPACT OF OPERATING AND FINANCIAL LEVERAGES
AND INTRINSIC BUSINESS RISK ON FIRM VALUE
Abstract:
This paper investigates and models the relationship between firm value and risk. In order to
model the impact of operating and financial leverages and intrinsic business risk on firm value
we extend both the theoretical and empirical issues of Mandelker and Rhee (1984) and Chung
(1989). We use panel data to estimate operating and financial leverage degrees and 403
sample non-financial USA firms for the period from 1995 to 1999. Our empirical findings
suggest that the degree of operating leverage and intrinsic business risk explain a large portion
of the variation of excess return in dollar when firm’s sales are negatively correlated with the
market portfolio. In contrast, when firm’s sales are positively correlated with market portfolio,
the degree of operating leverage is embedded in the intrinsic business risk and a significant
portion of cross-sectional variation in the excess return in dollar can be explained by intrinsic
business risk and the degree of financial leverage.
Key words: Operating leverage, financial leverage, intrinsic business risk, firm value, non-
financial USA firms.
Introduction:
2
of operating risk and showed that that risk reflects the combined effects of operating leverage,
the pure systematic influence of economy wide events and uncertainty surrounding the firm’s
operating efficiency. Lev (1974) used a sample of power companies and found positive
relationship between operating decisions and the riskiness of its stocks. He showed
analytically and empirically that operating leverage, measured by the level of fixed costs is
positively related to the systematic risk. Gahlon and Gentry (1982) developed a model for
calculating beta that include the degree of operating leverage (DOL) and the degree of
financial leverage (DFL) as explicit variables. They used DOL and DFL as real-asset risk
measures. Furthermore, they analytically demonstrated how the DOL and DFL, along with the
coefficient of variation of revenue and a cash flow correlation coefficient, affect a security’s
systematic risk, expected return and value. Mandelker and Rhee (1984) provided empirical
evidence that the degrees of operating and financial leverages explain 38 to 48 percent of the
cross-sectional variation in beta at the portfolio level. A major contribution of the Mandelker
and Rhee (1984) model compared to Hamada (1972) and Rubinstein (1973) models is that it
uses leverage values based on accounting flow numbers rather than market stock numbers.
Chung (1989) conducted both analytical and empirical studies on the relationship between
beta and DOL, DFL and demand beta, as a measure of intrinsic business risk. Using randomly
selected samples from manufacturing and utility industries, the same author showed that a
significant portion of the cross-sectional variation of beta can be explained by the cross-
sectional difference in the demand beta and the degrees of financial and operating leverages.
In order to drive meaningful policy implications from analysing the determinants of
firm value, decision variables such as assets, capital structures and business risk are taken into
account. In this study, we use the Capital Asset Pricing Model (CAPM), and both the
theoretical and empirical works of Mandelker and Rhee (1984) and Chung (1989) to develop
a model that establishes a theoretical relationship between firm value and risk, as measured by
the degrees of operating and financial leverages, and the intrinsic business risk.
Under Modigliani and Miller economic conditions the rate of return on common stock i for
the period from t-1 to t is defined as follows:
3
According to the Capital Asset Pricing Model (CAPM), the one period rate of return on
common stock i for the period from t-1 to t is defined by:
Cov(Ri,t, Rm,t )
Ri,t R f (E(Rm,t ) R f ) (2)
V(Rm,t )
Cov(NIi,t,Rm,t )
NIi,t (E(Rm,t ) R f )
V(Rm,t ) (5)
Vi,t 1
Rf
Cov(NIi,t, Rm,t )
NIi,t R f Vi,t 1 (E(Rm,t ) R f ) (6)
V(Rm,t )
We define DOL and DFL as measures of the degrees of operating and financial
leverages respectively. The degree of financial leverage (DFL) is defined as the percentage
change in earnings available to common stockholders associated with a given percentage
change in earnings before interest and taxes. The degree of operating leverage (DOL) is
defined as the percentage change in operating income (or earnings before interest and taxes)
that results from a given percentage changes in sales. Financial leverage reflects the amount
of debt used in the capital structure of the firm, but operating leverage measures the effect of
fixed cost. Mathematically, DFL and DOL can be calculated by using equations (8) and (9).
NIi,t 1
Percentage change in NI
DFL NIi,t 1 (8)
Percenatge change in EBIT EBITi,t 1
EBITi,t 1
4
Thus equation (8) can be rewritten as follows:
EBITi,t
Percentage change in EBIT EBITi,t 1 1
DOL (10)
Percentage change in sales Si,t 1
Si,t 1
From equation (10) it follows:
Cov NIi,t * NIi,t 1 ,Rm,t NIi,t 1*Cov NIi,t ,Rm,t (13)
NIi,t 1 NIi,t 1
Subtracting a constant equal to –1 from the first argument of the covariance term, equation
(13) can be rewritten as follows :
Cov NIi,t,Rm,t NIi,t 1*Cov NIi,t , Rm,t NIi,t 1*Cov NIi,t 1,Rm,t (14)
NIi,t 1 NIi,t 1
Substituting equation (12) into equation (14), we obtain:
5
Cov NIi,t, Rm,t DOL*DFL*Cov NIi,t 1 *Si,t, Rm,t (16)
NIi,t 1
Substitution of equation (16) into equation (6) yields:
The equation (17) can be expressed otherwise according to the general conditions of the
market or market prices. The rate of return on the market portfolio for period t-1 to t, can be
defined as follows once the rate of output of the market can be specified :
The variance of the rate of return on the market portfolio is equal to:
Cov NI i,t 1 *Si,t,Rm,t Cov NI i,t 1 *Si,t, NI m,t 1 Cov NIi,t 1 *Si,t , NI m,t (21)
Si,t 1 Si,t 1 Vm,t 1 Vm,t 1 Si,t 1
Using the decomposition of equations (19), (20) and (21), equation (17) becomes:
Both equations (17) and (22) show that the excess return in dollar, which is equal to
the expected net income minus a remuneration required by the market, can be expressed by
the degrees of operating and financial leverages, risk premium on the market portfolio and
intrinsic business risk. Intrinsic business risk can be defined differently as shown in equation
(17) and equation (22). The first equation defines the intrinsic business risk as the covariance
of the sales in dollar multiplied by the net profit margin at t-1 with the expected rate of return
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on the market portfolio, divided by the variance of the return on the market portfolio.
Mandhelker and Rhee (1984) demonstrated that four cases are possible and can magnify the
intrinsic business risk of excess return in dollar:
Firstly, the firm is both operationally and financially unlevered, thus DOL= DFL=1 and the
intrinsic business risk represents the principal source of riskiness on firm value. Secondly, the
firm is operationally levered and financially unlevered, thus DOL>1 and DFL=1, the excess
return in dollar is equal to degree of operating leverage multiplied by intrinsic business risk.
Thirdly, the firm is only financially levered (DOL=1 and DFL>1), the degree of financial
leverage magnifies the intrinsic business risk of the excess return in dollar. Fourthly, the firm
is levered, both operationally and financially (DOL>1 and DFL>1), and hence both DOL and
DFL have a non-linear multiplicative effect on the intrinsic business risk and thereby
determine the excess return in dollar.
We suggest to test empirically with real data if our theoretical findings can be
supported empirically, that is to say if a positive relationship between excess return in dollar
and the degrees of financial and operating leverages and the intrinsic business risk would exist
empirically.
Table 1
Summary of firms and industries in the sample
7
Paper and allied products 26 13 3.23%
Printing, publishing and allied 27 24 5.96%
Chemicals and allied products 28 72 17.87%
Petroleum refining and related industries 29 12 2.98%
Rubber and miscellaneous plastic products 30 15 3.72%
Leather 31 2 0.50%
Stone, clay, glass, and concrete products 32 7 1.74%
Primary metal industries 33 15 3.72%
Fabricated metal, expected machinery, 34 8 1.99%
transportation equipment
Machinery, expect electrical 35 69 17.12%
Electrical, electrical machinery, equipment, 36 60 14.89%
supplies
Transportation equipment 37 20 4.96%
Measuring instruments; photographic goods; 38 28 6.95%
watches
Miscellaneous manufacturing industries 39 4 0.99%
Total 403 100%
We start our analysis by trying to estimate the degrees of financial and operating
leverages. The empirical studies of Mandelker and Rhee (1984)1 and Chung (1989)2, use time-
series models to estimate the degrees of operating (DOL) and financial (DFL) leverages.
Differently we use panel data to measure both operating and financial risk for a five years
period. The sample of 403 non-financial USA firms is distributed in 45 sub-samples, that have
similar characteristics, and the number of observations per sub-sample varies from 35 to 65
observations.
In order to estimate the degrees of operating and financial leverages of all firms in the sample,
we refer to equations (8) and (9). The rearrangement of these equations gives:
(23)
EBITi,t EBITi,t 1 *DOLi *Si,t
Si,t 1
(24)
NIi,t NI i,t 1 *DFLi *EBITi,t
EBITi,t 1
The last two equations (23) and (24) are used to estimate the DOL and DFL with the
following specifications:
1
The study is based on a sample of 255 manufacturing firms during the period from 1957 to 1976.
2
The empirical investigation is based on 355 sample firms during the period from 1965 to 1983.
8
For each firm, we obtain daily stock returns (including dividends) from Just Quote and
North American Quotations during the period from 1995 to 1999. We require a firm to have at
least 1000 daily returns. Following Hamada (1972); Lev (1974); Mandelker and Rhee (1984);
Daves, Ehrhardt, Kuhlemeyer and Kunkel (2000), we use the well-accepted market model to
estimate the systematic risk of each common stock. Each stock’s beta is calculated using the
daily dividend adjusted returns over five years time period with the following OLS
regression:
Tables (2), (3) and (4) summarize the estimated coefficients of the degrees of operating
and financial leverages and the value of betas by industry.
9
Table 2 : Estimates of the degree of operating leverage by sub-sample
EBITi,t a0 a1Si,t i,t
10
Table 3: Estimates of the degree of financial leverage by sub-sample
NI i,t b0 b1EBITi,t i,t
11
Tables 2 and 3 exhibit parameters of the two groups of regressions used to calculate the
degrees of operating and financial leverages. In both tables, columns 1 show how firms are
distributed over 45 sub-samples under the 2-digit SIC Industry Code. Columns two and three
show values of the constants and t-values. Constants are not meaningful for most industries.
The coefficients’ estimate associated to sales and income before interest and tax are all
statistically significant at 1 percent level. R-square values are relatively high for most cases.
The F-values are all significant at 1 percent level. Degrees of operating and financial
leverages as presented in last columns and calculated by multiplying coefficients’ estimate
â1 and b̂1 respectively by S / EBIT and EBIT / NI .
Table 4 compares the average values of beta, the degree of operating leverage (DOL) and the
degree of financial leverage (DFL) for the 403 firms in the sample by industry.
From table 4. industries that present higher beta (with a value of more than 0,8) are Electrical,
electrical machinery, equipment, supplies (SIC code 36), Machinery expect electrical (SIC
code 35) and Chemicals and allied products (SIC code 28). Firms of these industries stand for
50 percent of the entire sample and show that the levels of DOL and DFL are very near of
unit. However, industries, whose beta is near to 0.5 like Textile mill products (SIC Code 22),
Lumber and wood products, expect furniture (SIC code 24), have average coefficients of
degrees of operating and financial leverages that exceed the unit. The last line of the same
table shows the total of firms in the sample and the average values of beta, DOL and DFL.
12
Table 5-1: Crossing between levels of degrees of operating and financial leverages for all
levels of systematic risk.
DFL 1 DFL > 1 Total
69 128 197
DOL 1
17.29% 32.08% 49.37%
59 143 202
DOL > 1
14.79% 35.84% 50.63%
128 271 399*
Total
32.08% 67.92% 100%
Table 5-2: Crossing between levels of degrees of operating and financial leverage with
different levels of systematic risk.
Beta 0.5 0.5 < Beta 1 Beta > 1
DFL 1 DFL > 1 Total DFL 1 DFL > 1 Total DFL 1 DFL > 1 Total Total
22 49 71 36 61 97 11 18 29 197
DOL 1
19.47% 43.36% 62.83% 17.56% 29.76% 47.32% 13.58% 22.22% 35.80% 49,37%
19 23 42 37 71 108 4 48 52 202
DOL >1
16.81% 20.35% 37.17% 18.05% 34.63% 52.68% 4.94% 59.26% 64.20% 50,63%
41 72 113 73 132 205 15 66 81 399*
Total
36.28% 63.72% 100% 35.61% 64.39% 100% 18.52% 81.48% 100% 100%
* The number of firms used for the frequency analysis is 399 instead of 403. For 4 firms it was not possible to
get a large number of observations to estimate beta coefficient.
Table 5-1 exhibit nearly the same proportions of the firms in the sample that have DOL more
or less than one (49.37 percent versus 50.63 percent). However, 128 firms have a DFL less or
equal to one and 271 firms have a DFL more than the unit. The asymmetry in classifying
firms of the sample can be explained by the fact that firms are assumed to abide more
financial than operational risk. The frequency analysis by interval of systematic risk, degree
of operating leverage and degree of financial leverage as summarized in the Table 5-2 that,
shows that the majority of firms has a level of systematic risk more than 0.5 but less than one.
Only 81 firms out of 403 have a beta superior to one. In all intervals of systematic risk the
percentage of firms that have a high degree of financial leverage ( DFL superior to one) is
more important than the percentage of firms that have a high degree of operational leverage
(DOL superior to one). Furthermore, the percentage of firms that have both DOL and DFL
more than one is an increasing function of the level of systematic risk. This result is relevant
with the hypothesis that the systematic risk is an increasing function of operating and
financial risks.
Cov (BN i,t 1 CAi, t 1)*CAi, t , Rm, t and Cov (BN i, t 1 CAi,t 1)*CAi,t , BN m,t .
The logarithmic transformations of both equations suppose that the sign of all variables are
positive what is not still the case. While the estimated values of the degrees of operating and
financial leverages as shown in the tables (2) and (3) present all positive sign, the calculated
values of the excess return in dollar and intrinsic business risk as defined by equations (17)
13
and (22), can be positive or negative signs. To overcome this problem, we suggest for each of
the two models two cases allowing to control signs of these different variables.
In the first case, the calculated excess return in dollar and intrinsic business risk have both
positive signs. The covariance operators as defined in models (17) and (22) indicate a positive
correlation respectively between sales of the firm and market portfolio rate of return, and sales
of the firm and the total of net income of all companies in the whole economy. In the second
case, calculated excess return in dollar and intrinsic business risk have both negative signs.
The correlation between the firm’s activity and the market portfolio is negative. This may be
explained by negative excess return in dollar. Both negative signs simplify themselves in both
models (17) and (25) since the first sign is associated with the explained variable and the
second sign is associated with the explanatory variables.
Tables 6 and 7 summarize respectively the results of the regressions of both models (17 and
22).
Table 6. The impact of the DOL, DFL and the intrinsic business risk (measured by the
covariance between the firm sale’s and market portfolio rate of return) on the excess return in
dollar.
LnRdti 0 1LnDOLi 2LnDFLi 3LnBi1i (28)
Constant DOL DFL i1 R2 R2 F
3.591* 1.011 1.669** 0.523* 0.325 0.303 15.220*
(21.010) (1.122) (2.072) (5.896)
3.575* 1.550** 0.546* 0.316 0.301 22.142*
(20.961) (1.939) (6.331)
3.632* 0.766 0.532* 0.294 0.279 19.997*
Case I: The calculated excess return in
dollar and intrinsic business risk have (21.047) (0.843) (5.902)
both positive signs. 3.292* 2.263** 1.895** 0.077 0.058 4.030**
(17.347) (2.223) (2.027)
3.334* 2.008** 0.038 0.028 3.830**
Number of observations: 99 firms
(17.398) (1.957)
3.223* 1.638*** 0.030 0.020 2.996***
(16.876) (1.731)
3.618* 0.549* 0.289 0.282 39.400*
(21.100) (6.277)
3.483* 1.466** -0.123 0.462* 0.330 0.306 13.775*
(26.519) (1.968) (-0.194) (6.026)
3.480* -0.244 0.461* 0.299 0.282 18.113*
(26.063) (-0.380) (5.918)
3.478* 1.480** 0.464* 0.329 0.314 20.879*
Case II: The calculated excess return (27.237) (2.007) (6.128)
in dollar and intrinsic business risk 3.476* 1.445*** -0.581 0.040 0.017 1.769
have both negative signs.
(22.246) (1.631) (-0.775)
Number of observations: 89 firms 3.450* 1.511*** 0.033 0.022 2.951***
(22.650) (1.718)
3.473* -0.699 0.010 0.002 0.862
(22.018) (-0.928)
3.470* 0.465* 0.298 0.289 36.445*
(26.720) (6.037)
* significant at the 0,01 level, ** significant at the 0,05 level, *** Significant at the 0,10 level.
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Table 7. The impact of the DOL, DFL and the intrinsic business risk (measured by the
covariance between firm’s sales and the total net income of all companies in the Sample) on
the excess return in dollar.
Tables (6) and (7) show cross-sectional regression results to test whether DOL, DFL
and intrinsic business risk have positive effects on the excess return in dollar. For each case,
seven regression results are reported. Numbers inside brackets represent t-value. The first line
reports in each case the estimated coefficients when all the explanatory variables are included
in the equation of regression. The second, third and fourth lines report the results when the
degree of operating leverage (DOL) or the degree of financial leverage (DFL) or the intrinsic
business risk is suppressed from the regression equations. The lines five, six and seven show
the estimated coefficients when only the DOL or DFL or the intrinsic business risk is used in
the regression model, respectively.
15
When the excess return in dollar and the intrinsic business risk are positive (Table 6;
case I), the degree of financial leverage and the intrinsic business risk explain 31.6 percent of
the cross-sectional variation of the excess return in dollar. The last line in table 6 case I shows
that the intrinsic business risk explains 28.9 percent of the variation of the excess return in
dollar. Whereas the degree of financial leverage explains only 3 percent of the variation of the
explanatory variable as reported in the sixth line. The DOL and DFL explain 7 percent of the
variation of the excess return in dollar when both are used as dependent variables in the cross-
sectional regression. Our results are consistent with the hypothesis of positive relationship
between operating and financial risks and the firm value.
Table 6 case II reports the regression results, when the excess return in dollar and the
intrinsic business risk are both negative. It is interesting to note that the sign expected of the
estimated coefficient of the degree of financial leverage is positive as hypothesized in the
regression model, whereas it has an opposite sign even though none of them is statistically
significant. Kmenta (1971) attribute the regression phenomenon to the specification error
resulting from the omission of a relevant independent variable in the regression equation. It is
worth noting that when the sample is formed with firms that have a phenomenon of
cyclicality (i, e., the intrinsic business risk) different from the market tendency, the relevant
explanatory variables are DOL and intrinsic business risk. The result of the cross-sectional
regression on firms that cause a wealth destruction to the shareholders, shows that intrinsic
business risk exhibits much higher explanatory power than does DOL ; 28.9 percent versus
3.3 percent.
Table 7 reports the regression results of the empirical model (29). This model defines
the intrinsic business risk as the covariance between the firm’s sales and the net income of all
firms in the economy. Results obtained in the Case I and Case II from the model (29) are
almost identical to those obtained in the model (28) with a net improvement of R-square
values. The degree of financial leverage and the intrinsic business risk are both associated
with positive and significant coefficients and allow to explain 49.4 percent of the variation of
excess return in dollar (Case I line 3). With the intrinsic business risk the explanatory variable
used in the regression, we find that alone it explains 48.2 percent. The explanatory powers of
both DOL and DFL indicate a weak relationship between these variables and the excess return
in dollar compared with the intrinsic business risk. The second case of the model (29) reports
the regression results when the explanatory variable of the intrinsic business risk and the
excess return in dollar are both negative. Our empirical findings show that firm’s activity
represents the most important role in the process of creation or destruction of firm value. The
intrinsic business risk and the degree of operating leverage explain 39 percent of the cross-
sectional variation in the excess return in dollar (Case II, line 1 and 3). It is worth noting that
35.4 percent of the variation of excess return in dollar may be due to variations in the intrinsic
business risk.
VI. Conclusion:
In this paper we tried to investigate the relationship between firm value and risk
according to the CAPM theoretical framework. Three measures of risks were used, degrees of
financial and operating leverages and intrinsic business risk. Using a panel of 403 US non-
financial firms for the period from 1995 to 1999, our results corroborate those of Mandelker
and Rhee (1984) and Chung (1989) in that return in excess is a positive and increasing
function of DOL, DFL and systematic risk for all firms in the sample that exhibit a positive
correlation between sale’ changes and market portfolio returns.
16
Our results are consistent with the hypothesis of positive relationship between
operating and financial risks and the firm value. A positive excess return in dollar seems better
explained by a leverage policy coupled with a less aggressive strategy on the market. A
negative excess return in dollar may be caused by an important level of fixed costs and
assuming a bad risk.
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