Companies are willing to take on more debt when their workers are shielded from the costs of joblessness through higher unemployment insurance provided by the government, according to a paper from New York University’s Stern School of Business and Northwestern’s Kellogg School of Management.
How do job security and the overall labor market factor into a company’s investment and financing decisions? Much of the answer seems to be that companies are concerned about their employees — so much so that they avoid over-leveraging for fear of plunging into a bankruptcy that might lead to layoffs.
In their recent paper, which won the 2010-11 NYU-Stern Glucksman Research Prize of $6,000 this spring, the authors studied changes in state unemployment-insurance benefit laws and corporate financing decisions of public firms in the U.S. These changes were used as a source of variation in the costs born by workers during layoff spells.
The results show that increases in legally mandated unemployment benefits lead to increases in corporate leverage. The impact of reduced unemployment risk on financial policy is especially strong for companies that have greater layoff separation rates, labor intensity, and financing constraints.
In fact, it costs a BBB-rated company about 57 basis points of firm value to compensate workers for unemployment risk due to financial distress, according to the research.
“Some believe that firms don’t seem to take on enough debt, and therefore don’t reap as much value in tax shields as they could, because interest income which accrues to debt holders is non-taxable,” Agrawal told Stern’s Faculty Research Brief. “Our paper argues that firms don’t take on high levels of debt because they are concerned about entering bankruptcy and being forced to fire workers, which in turn has implications for firms’ hiring and investment decisions.”
According to Agrawal, most existing research in corporate finance assumes that workers can easily relocate from one firm to another, that labor markets are frictionless.
“In contrast, our research suggests that labor market frictions have a significant impact on corporate financing decisions,” he notes. “On the heels of the financial crisis, we know how quickly the labor market can change, so it’s an important factor to consider when studying a firm’s financing and investment decisions.”