THE IMPACT OF OPERATING AND

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

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 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:

The purpose of this paper is to investigate fundamental risk determinants of firm

value. Financial theory is usually stated on the fact that the goal of the firm is to maximise
value and thus firms configure their balance sheets to achieve this goal. The selected structure
or configuration of liabilities and assets determines the total risk of the firm. Capital market
theory suggesting the Capital Asset Pricing Model (CAPM) of Sharpe (1964), Lintner (1965),
and Mossin (1966), clearly and explicitly specifies the relevant measure of risk of a security
issued by a firm (systematic or non-diversifiable risk). Systematic risk (  ) is a measure of
the sensitivity in determining an individual security’s return to the return of the market
portfolio and only the systematic risk is relevant in determining an individual security’s
return.
Two different but coherent sets of researches tried to provide financial managers
information about fundamental determinants of systematic risk. The first set of studies
empirically investigate correlations between market-determined and accounting-determined
risk measures (Ball and Brown (1969), Beaver, Kettler and Scholes (1970), Beaver and
Manegold (1975), Gonedes (1973), and Hill and Stone (1980) and the association between
macroeconomic factors and beta (Robicheck and cohn (1974). Myers (1977) has showed that
financial leverage, cyclicality, growth, and earnings’ volatility were determinants of beta.
These empirical works haven’t strong theoretical footing and they suffer from problems of
serious potential model misspecification. The second set of studies is theoretical and tried to
decompose mathematically the systematic risk into financial and economic factors. Brenner
and Smidt (1978) developed a model that explores the relationship between the systematic
risk of a security and the characteristics of the underlying real assets and demonstrated that
unit sales, fixed costs, contribution margin and covariance of sales are real determinants of
systematic risk.
Hamada (1972) found that, conditional on the validity of Modigliani and Miller’s
model, leverage accounts explain 21 to 24 percent of the cross-sectional variation in
systematic risk. Rubinstein (1973) defined the unlevered firm’s common stock beta in terms

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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.

II. The model

The flowing notation will be used through this section:

S i, t : the sales revenue of the firm i at time t,

EBITi,t : the earnings before interest and taxes of the firm i at time t,
NI i,t : the net income of the firm i at time t,
DFL : the degree of financial leverage of the firm i.
DOL : the degree of operating leverage of the firm i.
Ri, t : the rate of return on common stock i for the period from t-1 to t,
Rm, t : the rate of return on the market portfolio for the period from t-1 to
t,
Rf : the rate of return on a risk-free asset,
Vi, t 1 : the value of equity of the firm i at time t-1,

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:

Ri,t  NI i,t (1)

Vi,t 1

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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 )

Substitution of equation (1) into equation (2) yields:

Cov NIi,t ,Rm,t 

NIi,t  R f (E(Rm,t ) R f )  Vi,t 1  (3)
Vi,t 1 V(Rm,t )

Equation (3) can be rewritten as follows:

NI i,t  R f  1 (E(Rm,t ) R f ) Cov(NI i,t, Rm,t )

(4)
Vi,t 1 Vi,t 1 V(Rm,t )

The value of the firm can be expressed by :

Cov(NIi,t,Rm,t )
NIi,t (E(Rm,t ) R f )
V(Rm,t ) (5)
Vi,t 1 
Rf

The excess of return in dollar is given by the equation (6)

Cov(NIi,t, Rm,t )
NIi,t  R f Vi,t 1 (E(Rm,t ) R f ) (6)
V(Rm,t )

Solving for the covariance operator :

Cov(NI t , Rmt ) (7)

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

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Thus equation (8) can be rewritten as follows:

NIi,t 1 DFL* EBITi,t 1

  (9)
NIi,t 1  EBITi,t 1 
DOL is defined 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:

EBITi,t 1 DOL* Si,t 1

  (11)
EBITi,t 1  Si,t 1 
Substitution of equation (10) into equation (8) yields:

NIi,t 1 DFL*DOL* Si,t 1

  (12)
NIi,t 1  Si,t 1 
We can rearrange equation (7) by multiplying the first argument of the covariance by
BNi,t 1 :
BNi,t 1

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:

Cov NI i,t, Rm,t   NI i,t 1*DOL*DFL*Cov Si,t 1, Rm,t  (15)

 Si,t 1 
Mandelker and Rhee (1984) and Chung (1989) showed that DOL and DFL are not random
variables. Thus equation (15) can be rewritten as follows:

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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:

Cov (NI i,t 1 Si,t 1*Si,t ,Rm,t 

NIi,t  R f Vi,t 1 (E(Rm,t ) R f )*DOL*DFL* (17)
V(Rm,t )

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 :

Rm,t  NI m,t (18)

Vm,t 1
N
NI m,t  NI i,t where N is the number of firms in the economy.
i 1
N
Vm,t 1 Vi,t 1
i 1

The variance of the rate of return on the market portfolio is equal to:

V(Rm,t ) 1 *V(NI m,t )

(Vm,t 1)2 (19)

The market price of risk (E(Rm,t ) R f ) can be expressed as:

(E(Rm,t ) R f ) NI m,t  Rf  1 (NI m,t  Rf *Vm,t 1) (20)

Vm,t 1 Vm,t 1

The covariance in equation (17) can be decomposed as follows:

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:

Cov (NIi,t 1 Si,t 1)*Si,t, NI m,t 

NIi,t  R f Vi,t 1  NI m,t  R f Vm,t 1 *DOL*DFL* (22)
V(NI m,t )

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.

III. Data description risk measures and frequency crossing analysis

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.

A. Data set, and DOL and DFL estimation

The analysis is conducted on a sample of 403 non-financial USA corporations for the period
from 1995 to 1999, all available in Zack Investment Research Inc. and Market Guide Inc.
databases. To be included in the analysis sample, firms are required to have a proxy statement
for all years between 1995 and 1999. Table 1 summarizes the number of firms by industry
during the period from 1995 to 1999.

Table 1
Summary of firms and industries in the sample

Industry name Two-digit SIC Number of sample Percent of sample

code firms firms
Food and kindred products 20 24 5.96%
Textile mill products 22 4 0.99%
Apparel and other finished products 23 5 1.24%
Lumber and wood products, expect furniture 24 10 2.48%
Furniture and fixtures 25 11 2.73%

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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:

EBITi,t a0  a1Si,t  i,t (25)

And NI i,t b0 b1EBITi,t i,t (26)
Where  i,t and i,t are disturbance terms.
S S,t 1
Once a1 and b1 are estimated, the DOL is approximated by aˆ1* and the DFL is
EBIT S,t 1
EBIT S,t 1
approximated by bˆ1* , where S S,t 1 , EBIT S,t 1 and NI S,t 1 denote
NI S,t 1
respectively the average values of sales, earning before interest and tax, and net income of
firms in the sub-sample.

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.

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 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:

Ri,t  a   i *RM t  ei,t (27)

Where,
Ri, t = the return for company i on day t,
i = the estimate of beta
RM t = the return on S&P 500
a = the regression intercept
ei,t = the regression error
Daily return of standard and Poor 500 index is used as a proxy the daily rate of return of the
market portfolio.

Tables (2), (3) and (4) summarize the estimated coefficients of the degrees of operating
and financial leverages and the value of betas by industry.

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Table 2 : Estimates of the degree of operating leverage by sub-sample
EBITi,t a0  a1Si,t  i,t

Sic Code Constant t-value S t-value R2 R 2 F-value N Ob S / EBIT DOL

2000-2015 -24.890 -0.438 0.061* 13.234 0.826 0.821 175.14 40 17.192 1.048
2024-2060 -82.730 -1.470 0.147* 13.317 0.831 0.827 177.34 40 7.826 1.149
2082-2090 -32.149 -0.158 0.151* 5.618 0.489 0.473 31.57 40 6.694 1.014
22-23 -16.625 -1.548 0.077* 12.379 0.810 0.804 153.23 40 15.272 1.180
24 20.059 0.506 0.080* 9.702 0.677 0.669 94.12 50 11.321 0.900
25 62.643* 4.669 0.052* 18.028 0.864 0.862 325.01 55 13.609 0.701
26 75.609** 2.025 0.071* 12.952 0.740 0.735 167.76 65 11.302 0.806
2711 -201.254* -3.149 0.274* 12.180 0.823 0.817 148.35 35 5.094 1.395
2731-2750 14.896 0.932 0.098* 14.881 0.854 0.850 221.44 40 9.269 0.911
2761-2780 48.294 1.328 0.076* 3.458 0.226 0.207 11.95 45 7.826 0.977
2800-2821 -46.885 -0.828 0.157* 38.840 0.969 0.969 1508.57 50 6.624 1.040
2834 -10.962 -0.165 0.214* 28.510 0.955 0.954 812.81 40 4.725 1.011
2834 -53.495* -3.149 0.277* 99.401 0.996 0.996 9880.56 40 3.924 1.089
2834 -10.449 -0.268 0.243* 64.999 0.990 0.990 4224.81 45 4.146 1.007
2835-2840 78.081 1.567 0.149* 36.327 0.969 0.968 1319.66 45 5.920 0.880
2842-2851 -92.744** -2.565 0.165* 20.993 0.921 0.919 440.71 40 7.191 1.185
2860-2870 7.302 0.471 0.122* 17.909 0.882 0.879 320.72 45 7.902 0.961
2890 22.586 0.546 0.072* 7.465 0.537 0.528 55.73 55 12.566 0.904
29 -66.992 -0.576 0.076* 9.503 0.613 0.606 90.31 60 14.433 1.097
3011-3081 48.895 1.376 0.085* 13.522 0.832 0.827 182.85 40 9.958 0.846
3089 6.085 0.419 0.107* 10.458 0.732 0.726 109.37 45 8.750 0.620
32 23.214 0.763 0.117* 9.979 0.757 0.749 99.58 35 7.805 0.912
3310-3341 54.215* 3.196 0.043* 5.610 0.473 0.458 31.47 40 14.932 0.648
3357 10.762 0.519 0.089* 9.705 0.746 0.738 94.18 35 10.210 0.910
34 -163.43*** -1.873 0.165* 10.438 0.746 0.740 108.94 40 7.844 1.293
3511-3555 131.682 1.329 0.078* 9.036 0.630 0.622 81.64 50 10.170 0.798
3559 -38.890* -2.795 0.192* 20.724 0.909 0.907 429.50 45 6.796 1.302
3560-3569 32.866* 3.339 0.081* 9.405 0.728 0.720 88.46 35 8.501 0.685
3570-3571 -524.501* -2.751 0.117* 20.687 0.918 0.916 427.97 40 10.660 1.250
3572-3576 -117.106 -0.923 0.165* 5.931 0.450 0.437 35.18 45 7.696 1.272
3577-3585 12.269 0.421 0.134* 23.766 0.917 0.916 564.83 55 8.267 1.106
35 26.076 1.427 0.081* 6.986 0.569 0.557 48.80 40 9.775 0.789
35 -74.013 -1.059 0.138* 9.557 0.735 0.727 91.34 40 9.397 1.297
3600-3630 35.776*** 1.749 0.067* 14.862 0.870 0.866 220.88 35 12.705 0.849
3640-3661 23.452 1.198 0.128* 11.996 0.738 0.733 143.90 55 6.591 0.845
3663-3672 20.395 0.508 0.059* 13.471 0.791 0.786 181.46 50 15.520 0.910
3674 -30.645 -0.458 0.092* 5.422 0.436 0.421 29.40 40 12.758 1.176
3674 -8.058 -0.561 0.172* 8.105 0.666 0.655 65.69 35 6.398 1.099
3678-3690 -8.782 -0.496 0.118* 7.674 0.670 0.659 58.88 35 9.199 1.083
36 -2.852 -0.007 0.206* 6.789 0.606 0.593 46.10 35 4.589 0.946
3711-3716 -39.043 -0.324 0.097* 43.588 0.976 0.975 1899.88 50 10.575 1.021
3720-3751 46.797 0.178 0.096* 15.296 0.821 0.818 233.98 55 11.532 1.107
3812-3826 23.051* 3.208 0.071* 14.026 0.821 0.816 196.74 45 10.033 0.708
3829-3851 11.583 0.792 0.136* 10.827 0.701 0.695 117.22 55 6.500 0.885
3861-39 -21.422 -1.117 0.146* 43.976 0.972 0.971 1933.85 60 7.010 1.026
DOL : Degree of Operating Leverage
* significant at the 0.01 level, ** significant at the 0.05 level, *** significant at the 0.10 level.
All Fisher-values are significant at 0.01 level for all sub-samples.

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Table 3: Estimates of the degree of financial leverage by sub-sample
NI i,t b0 b1EBITi,t i,t

Sic Code Constant t-value EBIT t-value R2 R2 F-value N Ob EBIT / NI DFL

2000-2015 17.908 0.338 0.375* 5.480 0.448 0.433 30.03 40 2.441 0.915
2024-2060 42.904 0.826 0.407* 5.451 0.452 0.437 29.72 40 2.118 0.862
2082-2090 41.892 0.675 0.328* 6.908 0.591 0.579 47.72 40 2.712 0.889
22-23 -8.986 -1.658 0.424* 10.031 0.736 0.729 100.61 40 3.151 1.335
24 -10.283 -0.885 0.505* 19.962 0.899 0.896 398.50 50 2.202 1.112
25 2.829 0.389 0.470* 19.011 0.876 0.874 361.43 55 2.067 0.972
26 4.955 0.238 0.316* 8.789 0.567 0.560 77.24 65 2.890 0.912
2711 -59.449 -0.809 0.759* 6.426 0.563 0.550 41.29 35 1.575 1.195
2731-2750 4.068 0.211 0.538* 7.215 0.578 0.567 52.06 40 1.779 0.957
2761-2780 -6.439 -0.157 0.774* 4.018 0.282 0.265 16.14 45 1.974 1.194
2800-2821 -59.191 -0.400 0.644* 9.573 0.656 0.649 91.64 50 1.687 1.086
2834 -47.181 -0.665 0.682* 18.478 0.900 0.897 341.43 40 1.576 1.076
2834 -11.450 -0.391 0.669* 38.226 0.975 0.975 1461.26 40 1.538 1.029
2834 -64.502 -0.630 0.732* 18.173 0.885 0.882 330.27 45 1.449 1.061
2835-2840 4.522 0.569 0.623* 146.280 0.998 0.998 21397.96 45 1.627 1.014
2842-2851 -51.788** -2.378 0.586* 18.922 0.904 0.902 358.04 40 2.073 1.215
2860-2870 -26.195 -0.752 0.647* 5.439 0.408 0.394 29.58 45 1.974 1.276
2890 -15.913* -2.796 0.683* 49.088 0.980 0.980 2409.61 55 1.359 0.928
29 -51.746 -1.582 0.557* 21.063 0.886 0.884 443.65 60 2.074 1.155
3011-3081 1.670 0.085 0.475* 13.102 0.823 0.818 171.65 40 2.127 1.010
3089 29.447* 2.898 0.225* 3.669 0.252 0.233 13.46 45 2.271 1.140
32 -10.499 -0.205 0.336** 2.225 0.134 0.107 4.95 35 3.378 1.135
3310-3341 -13.824 -0.615 0.621* 4.286 0.344 0.325 18.37 40 2.113 1.311
3357 -12.094 -0.968 0.607* 10.785 0.784 0.777 116.31 35 1.867 1.134
34 -70.956 -1.530 0.529* 9.703 0.718 0.710 94.14 40 2.491 1.317
3511-3555 -31.794 -1.285 0.474* 21.564 0.906 0.904 464.99 50 2.352 1.115
3559 -8.558 -1.216 0.655* 25.843 0.940 0.938 667.87 45 1.700 1.113
3560-3569 -0.257 -0.061 0.554* 16.354 0.890 0.887 267.46 35 1.813 1.004
3570-3571 -70.706 -0.607 0.663* 21.185 0.922 0.920 448.80 40 1.589 1.054
3572-3576 -33.193 -0.757 0.604* 12.128 0.774 0.769 147.08 45 1.898 1.146
3577-3585 29.821 0.843 0.303* 6.177 0.428 0.417 38.15 55 2.120 0.642
35 -18.503 -1.600 0.619* 8.835 0.678 0.670 78.06 40 2.130 1.319
35 94.603*** 1.778 0.207* 2.803 0.192 0.168 7.85 40 1.752 0.362
3600-3630 2.254 0.134 0.548* 11.110 0.789 0.783 123.43 35 1.793 0.983
3640-3661 2.275 0.147 0.525* 9.161 0.622 0.615 83.93 55 1.934 1.015
3663-3672 -22.551 -0.708 0.558* 10.631 0.702 0.696 113.01 50 2.180 1.218
3674 -14.258 -0.334 0.857* 9.772 0.715 0.708 95.49 40 1.290 1.106
3674 -7.084 -1.281 0.691* 15.290 0.876 0.873 233.78 35 1.656 1.144
3678-3690 2.404 0.374 0.377* 8.756 0.726 0.716 76.67 35 2.525 0.952
36 -88.530*** -1.952 0.702* 53.413 0.990 0.989 2852.97 35 1.637 1.149
3711-3716 27.472 0.524 0.337* 34.018 0.961 0.960 1157.25 50 2.847 0.958
3720-3751 -64.253 -0.318 0.709* 15.484 0.825 0.821 239.76 55 1.440 1.022
3812-3826 -6.301 -1.061 0.490* 10.035 0.701 0.694 100.70 45 2.439 1.194
3829-3851 8.139 0.790 0.367* 6.515 0.454 0.444 42.44 55 2.196 0.807
3861-39 -25.955 -1.213 0.573* 22.500 0.900 0.899 506.25 60 2.015 1.154
DFL : Degree of Financial Leverage
* significant at the 0.01 level, ** significant at the 0.05 level, *** significant at the 0.10 level.
All Fisher-values are significant at 0.01 level for all sub-samples.

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.

Table 4: Estimates of average beta, DOL and DFL by industry.

Two-digit SIC code Number of firms Beta DOL DFL
20 d’entreprise
24 0.598 1.070 0.889
22-23 9 0.460 1.180 1.335
24 10 0.516 0.900 1.112
25 11 0.553 0.701 0.972
26 13 0.674 0.806 0.912
27 24 0.554 1.094 1.115
28 72 0.800 1.010 1.086
29 12 0.485 1.097 1.155
30-31 17 0.523 0.733 1.075
32 7 0.623 0.912 1.135
33 15 0.586 0.779 1.223
34 8 0.659 1.293 1.317
35 69 0.899 1.062 0.969
36 60 1.028 0.987 1.081
37 20 0.755 1.064 0.990
38-39 32 0.668 0.873 1.052
20-39 403 0.751 0.992 1.060
* DOL: the degree of operating leverage
* DFL: the degree of financial leverage

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.

B. Frequency analysis, sorting by risk

In order to better understand the typology of different risks we conduct a crossing analysis
within firms between DOL, DFL and betas.

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.

IV. Empirical validation of the model

We use theoretical equations (17) and (22) to examine the relationship between the
excess of return in dollar and its determinants. A logarithmic transformation of these
equations allows us to capture non-linear multiplicative effects of the degrees of financial and
operating leverages on the intrinsic business risk. The following empirical equations are used:

LnRdti 0 1LnDOLi 2 LnDFLi 3LnBi1i (28)

LnRdti '0 1' LnDOLi '2 LnDFLi '3 LnBi2  i' (29)
Where Rdti ,  i and  i are respectively equal to (BN i, t  R f Vi,t 1) ,
1 2

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 3LnBi1i (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.

14
 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.

LnRdti 0 1LnDOLi 2 LnDFLi 3 LnBi2  i (29)

Constant DOL DFL i2 R2 R2 F
-6.505* -0.059 0.967** 0.783* 0.494 0.485 54.320*
(-8.240) (-0.115) (1.959) (12.512)
-6.484* 0.973** 0.782* 0.494 0.488 81.954*
(-8.461) (1.991) (12.796)
-6.328* -0.173 0.771* 0.482 0.476 78.237*
Case I: The calculated excess return
in dollar and intrinsic business risk (-8.001) (-0.338) (12.277)
have both positive signs. 3.293* 1.249*** 0.370 0.019 0.008 1.663
(23.706) (1.799) (0.543)
3.304* 1.198*** 0.018 0.012 3.043***
Number of observations: 171 firms
(24.102) (1.744)
3.242* 0.202 0.001 -0.01 0.088
(23.683) (0.297)
-6.262* 0.767* 0.482 0.479 157.184*
(-8.188) (12.537)
-2.709* 1.444** -0.080 0.500* 0.390 0.372 22.163*
(-3.255) (2.459) (-0.14) (7.652)
-2.802* -0.110 0.507* 0.355 0.342 28.834*
(-3.292) (-0.18) (7.571)
-2.719* 1.446** 0.501* 0.390 0.378 33.550*
Case II: The calculated excess return (-3.296) (2.474) (7.705)
in dollar and intrinsic business risk 3.591* 1.616** -0.316 0.047 0.028 2.565***
have both negative signs.
(23.747) (2.213) (-0.43)
Number of observations: 108 firms 3.574* 1.623** 0.045 0.036 4.984**
(24.644) (2.232)
3.574* -0.353 0.002 -0.01 0.223
(23.240) (-0.47)
-2.817* 0.507* 0.354 0.348 58.167***
(-3.338) (7.627)
* significant at the 0,01 level, ** significant at the 0,05 level, *** Significant at the 0,10 level.

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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18