OPERATING LEVERAGE AND UNDERINVESTMENT

Using a contingent claims model, we examine the impacts of both operating leverage and financial leverage on a firm's investment decisions in the context of capacity expansion. Our model shows that quasi-fixed operating costs could significantly mitigate the underinvestment problem for debt-financed firms. The existing debt induces equity holders to delay equity-financed expansion because the expanded earnings base will also benefit the debt holders by lowering the bankruptcy risk. The operating costs decrease this type of wealth transfer from equity holders to debt holders by magnifying the bankruptcy risk of the existing debt upon investment. By applying the Cox proportional hazard model on a large sample of publicly traded U.S. firms over 1966-2016, we offer empirical support for the theoretical predictions. The results are robust to various measures of operating leverage.