The DOL-DFL Nexus: The Relationship between the Degree of Operating Leverage (DOL) and the Degree of Financial Leverage (DFL)

Abstract

In the present paper, I have modelled the Degree of Operating Leverage (DOL) and the Degree of Financial Leverage (DFL) using the percentage variations of the economic quantities. I devoted a great effort to encompass the investment dynamic and its financing mix to design a robust model implementable in a business context. The relationship discovered between DOL and DFL is complex and manifold: first, it appears asymmetrical because DOL can influence DFL, but the former is unrelated to the latter. Second, there is an infra-annual relationship measurable through partial derivatives. Eventually, the stress tests shed light on some long-term impacts of one-off shocks even when the steady-state conditions are restored, disclosing an inter-annual relationship. The DOL-DFL nexus appears to be negatively related, but I also discovered positive relations and unrelated conditions. As argued in the economic literature, they cannot always behave as substitutes. The mathematical DOL-DFL model developed can admit positive, negative, and unrelated relations even though management might intervene to choose the right combination. Also, the Business Case shows positive and negative relationships, both at the infra-annual and inter-annual levels. The DOL-DFL nexus depends on circumstances and management decisions. Empirical evidence should find how management uses such a nexus and how effective such decisions have been over time.