Inflexibility And Stock Returns
The University of Hong Kong
Boston University Questrom School of Business
Timothy C. Johnson
University of Illinois at Urbana-Champaign
July 1, 2015
Abstract:
Greater operating flexibility need not reduce expected returns or risk. In a neoclassical model of a firm with costly scale adjustment options, a distinguishing feature of low adjustment costs (i.e., high flexibility) is that risk and expected returns decline with operating leverage, whereas risk and expected returns rise with operating leverage for high in flexibility. Hence in flexibility increases the slope rather than the level of risk premia. Using measures of inflexibility and operating leverage, we provide evidence for cross-firm heterogeneity in real options and support for the model’s predicted interaction effect, which is present in returns and risk measures.
Inflexibility And Stock Returns – Introduction
Do more valuable operating options make stock returns safer and thereby lower expected returns? Intuition suggests that a firm’s real flexibility to respond to changes in operating conditions should be a key determinant of the risk its owners bear. Likewise, intuition suggests that risk should increase as a firm’s fixed costs rise relative to sales, due to operating leverage. In the context of a neoclassical model of a firm with scale adjustment options and operating costs, neither intuition is strictly correct.
Research on stock returns has focused on models of ex ante homogeneous firms that differ only in their history of idiosyncratic shocks. Homogeneity is a restrictive but useful assumption in otherwise complex models, and also enables the isolation of effects that are solely attributable to differences in productivity shocks.1 To the extent that models of ex ante homogeneous firms derive their results from variation in risk that stem from changes in the relative value of firms’ operating options, it is natural to study the implications of differences in option values across firms (as well as over time).
While the real options literature has long recognized that variation in option exercise costs can imply important differences in optimal policies (see, e.g., Abel, Dixit, Eberly, and Pindyck (1996) and Abel and Eberly (1996)), the implications of this heterogeneity has received little attention in the asset pricing literature. Moreover, there is empirical research on corporate investment that documents substantial differences across firms in the purchase and resale prices of physical capital.2 These differences are equivalent to differences in the value of operating options to increase or decrease a firm’s scale (i.e., flexibility). This study is among the first to explore the effect of cross-firm differences in real option values for the risk and expected return characteristics of a firm’s equity.
We consider a firm that is composed of assets-in-place, contraction options, and expansion options. The model is both rich enough to encompass ex ante heterogeneous firms, and yet simple enough to reveal general patterns of cross-firm variation in the value of these operating options for equity returns. The key state variable is the firm’s asset base scaled by its instantaneous operating prot, which increases monotonically with operating leverage. Firms inhabit different ranges of this state variable between their upper and lower scale adjustment boundaries, which are attributable to variation in their adjustment costs. Thus, the model’s first implication is that in flexibility can be summarized by the distance of these two operating boundaries (scaled by the volatility of the state variable), because the distance increases with in flexibility.
In the model, assets-in-place increase risk but real options may increase or decrease risk. Exercising the contraction option attenuates firm’s exposure to priced risk and exercising the expansion option has the opposite effect: it increases firm’s exposure to priced risk.3 The model’s second implication is that, perhaps contrary to intuition, the unconditional relation between exibility and equity risk premia need not be negative. Lowering some types of adjustment cost can raise expected returns and risk. The finding is not obvious: computing the unconditional effects requires not only solving the firms’ problem, but integrating over the (endogenous) distribution of operating states.
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