Optimal DOL (degree of operating leverage) with investment and production flexibility

Abstract

The purpose of this paper is to derive the optimal DOL (degree of operating leverage) of a company with flexibility in investment and production. The choice of DOL is a critical one because it impacts the company’s risk level, operating and financial performance, and valuation. However, there is virtually no research on how a company should choose its DOL. We address this gap in the literature, using a real-option model that incorporates important managerial flexibilities such as investment flexibility (to choose investment timing and capacity) and production flexibility (to change output level in response to demand-side changes). With a wide range of input parameter values, our model generates optimal DOL figures that are similar in magnitude to empirical estimates. We also identify the important determinants of DOL, such as costs (fixed cost, variable cost, and cost of capacity), demand characteristics (growth rate, volatility, and price-sensitivity), productivity of capital, and interest rate. How these inputs impact DOL depends on whether investment timing is exogenously specified or endogenously determined by the firm. Finally, capacity has been used in the literature as a measure of DOL, since capacity choice impacts DOL via fixed cost. However, we show that a number of other factors also affect DOL, and the relationship between capacity and DOL can be positive, negative, or non-monotonic. Thus, capacity is not a good proxy for DOL.