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Business uncertainty and financial leverage: should the firm double up on risk?

Business uncertainty and financial leverage: should the firm double up on risk? The purpose of this paper is to examine the nature of the relationship between business risk and financial leverage. While past theoretical and empirical studies on this topic use similar variables, overall, their findings are inconclusive. In this paper, the author contends this is partially due to inappropriate proxies for business risk that are commonly used in these research papers. To correct for this misspecification, this paper proposes an alternative proxy for business risk that is isolated from the effects of financial leverage.Design/methodology/approachPast research on the relationship between business risk and financial leverage uses some variations in a firm’s operating cash flow as a proxy for business risk. This proxy cannot solely reflect business risk and may very well be affected by the level of financial leverage, especially for financially distressed firms. This paper proposes an alternative proxy for business risk that is isolated from the effects of financial leverage. This proxy is the cost of capital of an all-equity firm. The theoretical model developed in this paper is based on deriving the optimum level of debt as a function of business risk in the context of the Modigliani and Miller Proposition II model.FindingsThe findings show a positive linkage between business risk and financial leverage. This relationship is robust to the various forms the cost of financial distress function may take.Originality/valueThe mixed findings in past research papers regarding the relationship between business risk and financial leverage are mainly due to “inappropriate” measures of business risk that do not only reflect one firm attribute and are contaminated with other factors mainly financial leverage. As such, since the variable of interest is misspecified, the outcome of these studies cannot be credible. This paper attempts to correct for such misspecification by proposing a proxy that only reflects business risk. In addition, the proposed model is based on the widely acceptable Modigliani and Miller static theory of capital structure. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Managerial Finance Emerald Publishing

Business uncertainty and financial leverage: should the firm double up on risk?

Elkhal, Khaled
Managerial Finance , Volume 45 (4): 9 – Apr 8, 2019
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References (33)

Publisher
Emerald Publishing
Copyright
© Emerald Publishing Limited
ISSN
0307-4358
DOI
10.1108/mf-10-2018-0491
Publisher site
See Article on Publisher Site

Abstract

The purpose of this paper is to examine the nature of the relationship between business risk and financial leverage. While past theoretical and empirical studies on this topic use similar variables, overall, their findings are inconclusive. In this paper, the author contends this is partially due to inappropriate proxies for business risk that are commonly used in these research papers. To correct for this misspecification, this paper proposes an alternative proxy for business risk that is isolated from the effects of financial leverage.Design/methodology/approachPast research on the relationship between business risk and financial leverage uses some variations in a firm’s operating cash flow as a proxy for business risk. This proxy cannot solely reflect business risk and may very well be affected by the level of financial leverage, especially for financially distressed firms. This paper proposes an alternative proxy for business risk that is isolated from the effects of financial leverage. This proxy is the cost of capital of an all-equity firm. The theoretical model developed in this paper is based on deriving the optimum level of debt as a function of business risk in the context of the Modigliani and Miller Proposition II model.FindingsThe findings show a positive linkage between business risk and financial leverage. This relationship is robust to the various forms the cost of financial distress function may take.Originality/valueThe mixed findings in past research papers regarding the relationship between business risk and financial leverage are mainly due to “inappropriate” measures of business risk that do not only reflect one firm attribute and are contaminated with other factors mainly financial leverage. As such, since the variable of interest is misspecified, the outcome of these studies cannot be credible. This paper attempts to correct for such misspecification by proposing a proxy that only reflects business risk. In addition, the proposed model is based on the widely acceptable Modigliani and Miller static theory of capital structure.

Journal

Managerial Finance – Emerald Publishing

Published: Apr 8, 2019

Keywords: Business risk; Financial distress; Financial leverage; G310; G320; G330; G390

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