A re-examination of the operating leverage-financial leverage tradeoff hypothesis.
Operating and financial leverage can be combined in a number of different ways
to obtain a desirable degree of overall leverage and risk of the firm. High operating
risk can be offset with low financial risk and vice versa (p. 731).
In other words, the hypothesis states that firms trade off their operating leverage and financial leverage to manage their level of overall risk.
To test the "tradeoff" hypothesis, M&R first used a time-series regression procedure to calculate degree of operating leverage (DOL) and degree of financial leverage (DFL) coefficients for a sample of 255 firms. The authors next formed three sets of portfolios by stratifying the sample on DOL, DFL, and beta, respectively. M&R then computed cross-sectional correlations between the DOL and DFL coefficient estimates for the three sets of portfolios. They found several statistically significant negative cross-sectional correlations between DOL and DFL. M&R concluded that these findings supported the "tradeoff" hypothesis.
In a subsequent paper, O'Brien and Vanderheiden (O&V) (1987) argued that the time-series regression approach used by M&R to estimate the DOL and DFL coefficients failed to control for the trend components in the sales and earnings series. To address this concern, O&V suggested a two-stage approach in which the trend components in the sales and earnings series are removed before the time-series regressions to estimate the DOL and DFL coefficients are performed. Based on their empirical results, O&V argued that the DOL estimates derived from their two-stage approach appeared to be more "intuitively plausible than the corresponding estimates from the M&R approach" (1987, p. 49)--though the authors did not re-examine the "tradeoff" hypothesis issue.
The objective of the current study is to examine whether firms that exhibit a relatively high degree of apparent tradeoff differ in financial attributes from firms that exhibit a relatively low degree of apparent tradeoff. The remainder of the article describes the research method, results, a summary and suggestions for future research.
This section describes: (1) the derivation of the final set of firms included in the study; (2) the econometric techniques utilized to calculate the firms' DOL and DFL coefficients, and the resultant classification of the firms into relatively high and relatively low tradeoff categories; and (3) the selection of the financial attributes ratios) to be analyzed and the hypothesis of the study.
Derivation of Sample
A final sample set of 79 firms was obtained from the COMPUSTAT industrial file. To be included in the sample, a firm needed to meet the following screening criteria:
1. be a manufacturing firm (SIC first-digit 2 or 3).
2. have Sales, Earnings before Interest and Taxes, Earnings before Extraordinary
Items, and other financial data available for the entire period 1971-1989
so DOL and DFL coefficients and various financial ratios could be
3. have positive values for Earnings before Interest and Taxes and Earnings
before Extraordinary Items for 1971-1989 so the logarithm operator could be
applied to those data to estimate the DOL and DFL coefficienls through the
use of time-series regression procedures.(1)
4. have a least four other firms in its four-digit SIC category with available data
so that industry median DOL and DFL coefficients and the financial ratios
could be calculated.
Table 1 documents the mortality that occurred in applying these screening criteria to derive the final sample set of 79 firms.
[TABULAR DATA 1 OMITTED]
Calculation of DOL and DFL Coefficients and Classification of Firms
For each firm in the sample, both the Mandelker and Rhee (M&R) and the O'Brien and Vanderheiden (O&V) time-series regression estimation techniques were used to generate DOL and DFL coefficients. Dugan and Shriver (1992) compared the M&R and O&V estimation techniques and found that the M&R and O&V estimates of DOL differ significantly across industries and over estimation periods. Because of these differences, both the M&R and O&V approaches to calculating DOL and DFL are used in the current study to assess the sensitivity of the results to the choice of estimation technique.
Each firm's DOL and DFL coefficients were adjusted for industry-related factors by subtracting the firm's industry median DOL and DFL. The industry median DOL and DFL coefficients were calculated by applying the same DOL and DFL estimation procedures to all of the remaining firms from the same four-digit SIC industry category with available data on COMPUSTAT and then computing the median values of DOL and DFL for those remaining firms (i.e., a jackknifed approach).(2) For the remainder of the article, references to a firm's DOL and DFL coefficient values pertain to the firm's industry median-adjusted DOL and DFL coefficient values.
The sample firms then were cross-classified into low-high DOL and low-high DFL groupings, where the threshold for the low-high classification was at the respective median DOL and DFL coefficient values for the sample. A 2x2 matrix depicting the DOL and DFL groupings was formed. The finns in the off-diagonal cells (the low DOL-high DFL cell and high DOL-low DFL cell) were assumed to exhibit a relatively high degree of apparent tradeoff between operating and financial leverage. Those firms in the diagonal cells (the low DOL-low DFL and high DOL-high DFL cells) were assumed to exhibit a relatively low degree of apparent tradeoff. Statistical analyses were then performed between the relatively high tradeoff (off-diagonal) and relatively low tradeoff (diagonal) firms to compare the two groups of firms on nine industry median-adjusted ratios,(3) as discussed in the next section.
Selection of Financial Attributes (Ratios) to Be Analyzed and the Hypothesis of the Study
As stated previously, the purpose of this study is to examine whether firms that exhibit a relatively high degree of apparent tradeoff differ in financial attributes from firms that exhibit a relatively low degree of apparent tradeoff. In order to address this issue, theoretical and empirical papers were analyzed in order to identify financial attributes ratios) which are related to the financing and investing decisions of a firm (in a tradeoff hypothesis context).
Pinches, Mingo, and Caruthers (1973) identified the following ratios which may be proxies for the inherent financial attributes of firms (after implementing various financing and investing decisions):
1. current ratio,
2. acid-test ratio,
3. return on assets,
4. return on owners' equity,
5. inventory turnover,
6. receivables turnover,
7. cash to total assets, Also, recent studies (e.g., Changand Rhee (1990); Titman andwessels (1988)) suggest that the following additional ratios are relevant to the objective of this study:
8. percentage change in total assets growth),
9. coefficient of variation of earnings before extraordinary items (earnings variability).
In summary, the research hypothesis addressed in this study may be stated in nondirectional alternative form as follows:
[H.sub.A]: The relatively high tradeoff firms differ in financial attributes (current ratio,
acid-test ratio, return on assets, return on owners' equity, inventory turnover,
receivables turnover, cash to total assets, percentage change in total assets, and
coefficient of variation of earnings before extraordinary items) from the relatively
low tradeoff firrns.
For both the M&R and O&V estimation techniques, 40 of the 79 firms were classified as relatively low tradeoff firms, while 39 were classified as relatively high tradeoff firms. Though the same number of firms was classified into the relatively low and relatively high tradeoff categories under both estimation techniques, the composition of the firms within each category differed between the two techniques. Table 2 reports the results of the tests of mean differences between the relatively high tradeoff and relatively low tradeoff firms' ratios using the M&R estimation technique for DOL and DFL coefficients. The results suggest that no significant differences exist between the relatively high tradeoff and relatively low tradeoff firms' ratios across an array of financial attributes (ratios).
Table 2. TEXT OF MEAN DIFFERENCES IN FINANCIAL ATTRIBUTES BETWEEN RELATIVELY HIGH TRADEOFF AND RELATIVELY LOW TRADEOFF FIRMS USING M&R DOL AND DFL ESTIMATES (t-Test for Independent Samples) Mean for Mean for Relatively High Relatively Low T-test for Tradeoff Firms Tradeoff Firms Difference In Ratio (N=39) (A=40) Means P-Value CR -.0464 .0151 .6245 .5341 AT -.0467 .0224 .7124 .4784 ROTA .0059 .0005 -1.1140 .2688 ROTOE .0023 -.0004 -.2624 .7939 IT 1.0026 -.2482 -1.0700 .2886 RT .0068 .1874 .5358 .5936 CITA .0029 -.0116 .9183 .3613 PCRA .0107 .0055 -.5803 .5635 CVEBEI .0541 .0344 -.4517 .6528 Notes: CR = current ratio AT = acid-test ratio ROTA = return on total assets ROTOE = return on total owners' equity It = inventory turnover RT = receivables turnover CTTA = cast to total assets PCTA = percentage change in total assets CVEBEI = coefficient of variation of earnings before extraordinary items
Table 3 provides the results of the tests of mean differences between the relatively high tradeoff and relatively low tradeoff firms' ratios using the O&V estimation technique for DOL and DFL coefficients. The results indicate that significant differences exist between the relatively high tradeoff and relatively low tradeoff firms' mean ratios for the following financial attributes: return on total assets (p-value = .0600), return on total owners' equity (p-value = .0630), and cash to total assets (p-value = 0776).(4) In addition, a marginally significant difference was observed for inventory turnover (p-value =.1004).
Table 3. TEST OF MEAN DIFFERENCES IN FINANCIAL ATTRIBUTES BETWEEN RELATIVELY HIGH TRADEOFF AND RELATIVELY LOW TRADEOFF FIRMS USING O&V DOL AND DFL ESTIMATES (t-Test for Independent Samples) Mean for High Mean for Low T-Test for Tradeoff Firms Tradeoff Firms Difference In Ratio (N=39) (N=40) Means P-Value CR .0137 -.0435 -.5808 .5631 AT .0146 -.0374 -.5349 .5943 ROTA .0077 -.0013 -1.9089 .0600 ROTOE .0105 -.0085 -1.8865 .0630 IT .1.3492 -.5862 -1.6693 .1004 RT .1609 .0371 -.3653 .7159 CTRA .0158 -.0009 -1.7884 .0776 PCTA .0097 .0065 -.3525 .7254 CVEBEI .0537 .0347 -.4317 .6672 Notes: CR = current ratio AT = acid-test ratio ROTA = return on total assets ROTOE = return on total owners' equity IT = inventory turnover RT = receivables turnover CTTA = cast to total assets PCTA = percentage change in total assets CVEBEI = coefficient of variation of earnings before extraordinary items
The above results from Table 3 provide evidence that relatively high tradeoff firms differ significantly from relatively low tradeoff firms with respect to the following financial attributes (ratios): return on total assets, return on total owners' equity, and cash to total assets (when the O&V estimation technique was utilized to estimate the DOL and DFL coefficients). Additionally, the relatively high tradeoff firms have higher return on total assets, return on total owners' equity, and cash to total assets ratios as compared to those of the relatively low tradeoff firms (on the average). This result suggests that firms exhibiting a relatively high tradeoff between operating and financial leverage may be more successful in terms of profitability and cash position.
SUMMARY AND SUGGESTIONS FOR FUTURE RESEARCH
This study examined whether firms that exhibit a relatively high degree of apparent tradeoff differ in financial attributes from firms that exhibit a relatively low degree of apparent tradeoff. The results provide evidence that relatively high tradeoff firms differ significantly from relatively low tradeoff firms with respect to certain financial attributes (ratios), though the results are sensitive to the choice of estimation technique for calculating the degree of operating leverage and degree of financial leverage coefficients.
Given the sensitivity of the results to choice of estimation technique, future research might be directed toward refinement of the estimation of the degree of operating leverage and degree of financial leverage coefficients. The time-series regression procedures employed by Mandelker and Rhee (1984) and O'Brien and Vanderheiden (1987)--and used in the current study--assume that those coefficients are constant over the estimation period, because they represent the slope estimates of time-series regression lines. On the other hand, the "tradeoff" hypothesis implies that both leverage measures change over time in response to attempts on the part of a firm's financial management to trade off operating and financial leverage. Thus, an inconsistency appears to exist between the underlying assumptions of the time-series regression estimation techniques and the theoretical implications of the "tradeoff" hypothesis. Future research is encouraged to resolve this apparent inconsistency.
(*) Direct all correspondence to: Michael T. Dugan, The University of Alabama, Culverhouse School of Accountancy, Box 870220, Tuscaloosa, AL 35487-0220. (**) We appreciate the helpful comments of Emmett Griner, Benton Gup, John Jahera, two anonymous reviewers, and the editor on earlier drafts of this paper. Professor Dugan is grateful for the summer financial support provided by The University of Alabama Culverhouse School of Accountancy. Professor Shriver is grateful for the financial support provided by the Arizona State University College of Business Summer Research Grant program. (1.) Though Mandelker and Rhee (1984) used an alternative approach (documented in footnote six of their paper) to estimating DOL and DFL coefficients for firms with negative earnings values, an analogous alternative approach for the O'Brien and Vanderheiden (1987) estimation technique has not appeared in the literature. Accordingly, this sample screening criterion is necessary for the current study. (2.) Medians are used as a measure of industry "central tendency" for DOL and DFL because they tend not to be as greatly influenced by the presence of outlier observations as are means. (3.) To determine the industry median-adjusted ratios, each ratio was computed for each firm each year, and for each firm these annual ratios were averaged across the 1971-1989 period. For each ratio, the industry median then was subtracted from the firm's mean ratio in order to obtain the industry median-adjusted ratios. (4.) This parametric t-test of mean differences was repeated using the nonparametric Mann-Whitney U test for the median differences between the relatively high and relatively low tradeoff firms using both the M&R and O&V estimation techniques. In both cases the results were very similar to those obtained from the parametric t-tests.
 Chang, Rosita and S. Ghon Rhee. 1990. "The Impact of Personal Taxes on Corporate Dividend Policy and Capital Structure Decisions." Financial Management 19: 21-31.  Dugan, Michael and Keith Shriver 1992. "An Empirical Comparison of Alternative Methods for the Estimation of the Degree of Operating Leverage." Financial Review 27: 309-321.  Mandelker, Gershon and S. Ghon Rhee. 1984. "The Impact of the Degrees of Operating and Financial Leverage on Systematic Risk of Common Stock." Journal of Financial and Quantitative Analysis 19: 45-57.  O'Brien, Thomas and Paul Vanderheiden. 1987. "Empirical Measurement of Operating Leverage for Growing Firms." Financial Management 16: 45-53.  Pinches, George, Kent Mingo, and J. Kent Caruthers. 1973. "The Stability of Financial Patterns in Industrial Organizations." Journal of Finance 28: 389-396.  Titman, Sheridan and Roberto Wessels. 1988. "The Determinants of Capital Structure Choice." Journal of Finance 43: 1-19.  Van Horne, James. 1977. Financial Management and Policy. Englewood Cliffs, NJ: Prentice-Hall.
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|Author:||Dugan, Michael T.; Minyard, Donald H.; Shriver, Keith A.|
|Publication:||Quarterly Review of Economics and Finance|
|Date:||Sep 22, 1994|
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