A note on operating leverage and expected rates of return

Conventional wisdom, used to explain the value premium, is that greater operating leverage increases systematic risk and therefore leads to a higher expected rate of return earned by a firm's owners. This paper shows that the relationship between operating leverage and the expected return is actually non-monotonic when allowance is made for the option to abandon an unprofitable project: the expected return is an increasing function of operating leverage when the latter is low, but a decreasing function when it is high. This demonstrates the dangers in drawing inferences from models that ignore the flexibility embedded in typical investment projects.