OPERATING LEVERAGE AND UNDERINVESTMENT

Date01 September 2019
Published date01 September 2019
DOIhttp://doi.org/10.1111/jfir.12188
The Journal of Financial Research Vol. XLII, No. 3 Pages 553587 Fall 2019
DOI: 10.1111/jfir.12188
OPERATING LEVERAGE AND UNDERINVESTMENT
Feng Jiao
University of Lethbridge
Michi Nishihara
Osaka University
Chuanqian Zhang
Yangtze Normal University and William Paterson University
Abstract
Using a contingent claims model, we examine the impacts of both operating leverage
and financial leverage on a firms investment decisions in the context of capacity
expansion. Our model shows that quasifixed operating costs could significantly
mitigate the underinvestment problem for debtfinanced firms. The existing debt
induces equity holders to delay equityfinanced expansion because the expanded
earnings base will also benefit the debt holders by lowering the bankruptcy risk.
The operating costs decrease this type of wealth transfer from equity holders to
debt holders by magnifying the bankruptcy risk of the existing debt upon investment.
By applying the Cox proportional hazard model on a large sample of publicly
traded U.S. firms over 19662016, we offer empirical support for the theoretical
predictions. The results are robust to various measures of operating leverage.
JEL Classification: G31
I. Introduction
Operating leverage can be interpreted analogously to financial leverage because both
involve fixed periodic payments. In particular, the former is generated by fixed or
quasifixed operating costs, whereas the latter is characterized by coupon payments.
Recently, a strand of the empirical literature has documented that operating leverage
can undermine a firms incentive to undertake capital investments (Cho 2018;
Gustafson and Kotter 2018). This result is parallel to the wellestablished fact that
financial leverage also has a negative impact on corporate investments (Myers 1977;
Diamond and He 2014). However, given the similarity between the two leverages, we
We thank Marc Arnold and Jieying Hong (discussant) as well as participants at the 2018 Financial
Management Association annual meeting for their constructive suggestions on an early draft. Part of this work
was conducted when Zhang visited Osaka University and he wholeheartedly appreciates their hospitality. Zhang
also thanks the Summer Research Fellow of Cotsakos College of Business at William Paterson University and
National Science Foundation of China (No. 71702013) for their financial support. Nishihara gratefully
acknowledges financial support from JSPS KAKENHI (Grant Nos. 17K01254 and 17H02547).
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© 2019 The Southern Finance Association and the Southwestern Finance Association
still lack an understanding of how they are distinct from each other and how they
interrelate with regard to investment decisions. In this article we attempt to fill this gap
by addressing the following questions: How does operating leverage influence a firms
investment decisions? How do operating leverage and financial leverage jointly shape a
firms investment decisions?
To this end, we build a dynamic structural model where corporate value and
decisions are governed by a single variable, namely, market demand, and this
variable evolves in a diffusive process. The firm has an expansion opportunity to
increase its current production capacity to a higher level. We introduce operating
leverage as the quasifixed operating costs that grow in proportion to the size of the
installed capitals but are independent of the sales performance. We assume that the
operating costs are largely dependent on the production technology with which the
firm operates, and they are supposed to be exogenous. Before the investment,
equity holders have an existing console bond that incurs constant coupon payments.
Debt renders the firm risky, as if the firm were unable to generate enough cash
flows to cover the interest payment either by profitable production or by issuing
new equity, it would go bankrupt. When the bankruptcy trigger is hit before the
investment happens, debt holders are assumed to take over all of the unleveraged
assets, and their value is derived from future sales and operating costs. If the market
demand declines to an even lower level, debt holders have to liquidate the capital
stock with zero value. Equity holdersgoal is to select the optimal investment and
default thresholds to maximize their ex ante market value.
Our model has two major implications. First, regarding the impact of
operating leverage on investment decisions, we show that all else being equal, high
fixed operating costs discourage capacity expansion. High operating costs can
increase liquidation risk upon expansion and hence induce higher breakeven points
for the project to be invested. This feature conforms to the conventional wisdom
that fixed operating costs behave in a comparable fashion to debt servicing (i.e.,
fixed periodic payments) and induce underinvestment akin to the debt overhang
problem.
Second, the joint effect of the two types of leverage on investment is
positive. Specifically, when operating costs are relatively low, the investment
threshold increases monotonically with financial leverag e, whereas when
operating costs are relatively high, the investment threshold has a flat relation
with financial leverage. Risky debt causes the debt overhang problem because
although equity holders bear all of the investment costs, debt holders reap part of
the benefits. Because they anticipate a wealth transfer from equity holders to debt
holders, shareholders bypass some projects with a positive net present value
(NPV). In our model, operating leverage can mitigate the debt overhang problem
via the following mechanism: a high level of fixed operating cost raises the
postinvestment default threshold and amplifies the default probability, which leads
to a lower expected value of debt. As fewer benefits are reaped by debt holders,
this event effectively creates a reverse wealth transfer from debt holders to equity
holders. Depending on the size of the fixed operating costs, this reverse wealth
transfer could mitigate or even eliminate the wealth transfer channel mentioned
554 The Journal of Financial Research
earlier.
1
To the best of our knowledge, this novel interaction between operating
leverage and underinvestment is not documented in the literature. Furthermore,
this outcome is not driven by a simple substitution between these two firm
characteristics.
After deriving our model predictions, we test them empirically. We employ three
measures of operating leverage that are popular in the literature (GarcíaFeijóo and Jorgensen
2010; NovyMarx 2011; Chen, Harford, and Kamara 2019). Then, we carry out the empirical
tests using a large panel covering 16,169 publicly traded firms from 1966 to 2016. Following
Leary and Roberts (2005), Whited (2006), and Morellec, Valta, and Zhdanov (2015), we
estimate a mixed proportional hazard model and find that a onestandarddeviation rise in
operating leverage decreases the investment hazard rate by approximately 4.1%. The
evidence suggests that operating leverage can mitigate the negative relation between financial
leverage and investment. When operating leverage increases by one standard deviation, the
marginal effect of financial leverage on investment is expected to be weakened by 16.43%.
These empirical findings are consistent with the model predictions. Our findings are robust to
alternative proxies of operating leverage and financial leverage.
In addition, we conduct several exercises to alleviate the endogeneity concern
pertaining to operating leverage. First, we perform industrylevel estimations as a robustness
check. Because industrylevel operating leverage is largely determined by the production
technology with which the firm operates,
2
it is more likely to be exogenous compared to
operating leverage at the firm level. Second, since China joined the World Trade
Organization (WTO) in December 2001, the fixed operating costs of U.S. manufacturers
have grown significantly as firms quickly switched from laborintensive to capitalintensive
production technologies (Pierce and Schott 2016; Chen, Harford, and Kamara 2019).
Consequently, we use Chinas WTO entry as an instrument to mitigate the endogeneity
concern. Third, to account for the possibility of omitted covariates, we augment our
proportional hazard model by including unobserved heterogeneity across firms.
Our article is related to two strands of the literature. First, we contribute to related
works (both theoretic and empirical) on identifying the determinants of the debt overhang
problem. For example, studies have investigated an array of financial leverageside (or
external debt) factors such as debt renegotiation by Pawlina (2010) and Alanis, Chava, and
Kumar (2018), debt priority structure by Hackbarth and Mauer (2012), shortterm debt by
Diamond and He (2014), and debt enforcement by Favara et al. (2017). We complement
their work by exploring the impact of operating leverage (or internal debt), which is largely
ignored by these studies. In particular, Arnold, Hackbarth, and Puhan (2018) find that
investments financed by asset sales suffer less from the underinvestment problem. Hirth and
UhrigHomburg (2010) reveal that cashfinanced investments can eliminate the debt
overhang problem. Both of these studies essentially show a reverse wealth transfer process
1
Though theoretically possible, the mitigation effect of operating leverage is not strong enough to
completely offset the underinvestment problem empirically. We evaluate the economic significance in
Section IV.
2
For example, firms in the pharmaceutical industry are considered to have high operating leverage. The
pharmaceutical industry could spend millions to develop a novel drug, but need only pennies to manufacture it.
555Operating Leverage and Underinvestment

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