Fama's Ratio and the Effect of Operating Leverage on the Cost of Capital Under CAPM. (29th June 2020)

• Record Type: Journal Article
• Authors: Johnstone, David
• Is Part Of: Abacus. Volume 56:Number 2(2020:Jun.)
• Page Start: 268
• Page End: 287
• Publication Date: 2020-06-29
• Subjects: CAPM -- Cost management -- Cost of capital -- Operating leverage; Accounting -- Periodicals; Finance -- Periodicals; 657.05
• DOI: 10.1111/abac.12191
• Languages: English
• ISSNs: 0001-3072

Abstract

Abstract : The firm's operating leverage is its ratio of fixed to variable costs. It is widely understood that production settings with higher fixed costs and lower variable costs are high risk. Well‐rehearsed CAPM arguments show how the firm's beta and cost of capital is higher when its proportion of fixed costs is higher. Importantly, that generalization holds under CAPM if expected total costs are constant and merely re‐apportioned between fixed and variable, but does not hold if expected total costs change. In actual business contexts, higher fixed costs are intended to bring lower unit variable costs and often lower expected total costs. Allowing for such efficiency gains, the firm's risk‐adjusted cost of capital might typically fall despite the higher operating leverage. Formal proof follows directly from the payoffs or 'certainty equivalent' expression of CAPM. The CAPM insights and new CAPM equations brought to light in this proof are surprising and useful.