Research Highlights
Unemployment Risk Affects Corporate Financing Strategy
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In particular, managers are reluctant to take on very risky financing strategies if it means that they will have to pay greater wages to compensate labor for working in a less stable company.
By Ashwini Agrawal, Assistant Professor of Finance
Markedly high US unemployment continues to plague the economy and any chance of a quick recovery. Yet while its effect on the worker is widely understood, new research reveals a lesser known connection between unemployment and corporate financing. NYU Stern Finance Professor Ashwini Agrawal, with co-author David Matsa from Northwestern Kellogg School of Management, finds that public firms make less risky financial decisions in order to protect their workers from entering unemployment.
The authors argue that workers require greater compensation for jobs that are highly risky, all things considered. That is, workers are more willing to accept lower salaries in exchange for more stable employment prospects. Managers take the relationship between wages and unemployment risk into account when they make financing decisions. In particular, managers are reluctant to take on very risky financing strategies if it means that they will have to pay greater wages to compensate labor for working in a less stable company.
To empirically identify the link between worker unemployment risk and corporate financing decisions, the authors document changes in unemployment insurance (UI) benefit laws across 50 states in the US from 1950 to 2008. A number of prior studies have found that increases in public UI assistance lowers workers’ unemployment costs, and hence reduces the wage burdens faced by firms. The authors find that when managers become less saddled by employee wage demands, firms are more able to shift their capital structures towards risky debt financing, since bankruptcy is less threatening to workers.
More specifically, the authors find that doubling UI benefits causes firms to increase debt-to-asset ratios by at least 4 percent. The effects are particularly large for firms that employ low-wage workers and experience frequent layoffs, such as construction and manufacturing companies. Furthermore, the increases in debt financing yield significant tax savings for firms, due to the tax deductibility of interest payments.
The authors argue that workers require greater compensation for jobs that are highly risky, all things considered. That is, workers are more willing to accept lower salaries in exchange for more stable employment prospects. Managers take the relationship between wages and unemployment risk into account when they make financing decisions. In particular, managers are reluctant to take on very risky financing strategies if it means that they will have to pay greater wages to compensate labor for working in a less stable company.
To empirically identify the link between worker unemployment risk and corporate financing decisions, the authors document changes in unemployment insurance (UI) benefit laws across 50 states in the US from 1950 to 2008. A number of prior studies have found that increases in public UI assistance lowers workers’ unemployment costs, and hence reduces the wage burdens faced by firms. The authors find that when managers become less saddled by employee wage demands, firms are more able to shift their capital structures towards risky debt financing, since bankruptcy is less threatening to workers.
More specifically, the authors find that doubling UI benefits causes firms to increase debt-to-asset ratios by at least 4 percent. The effects are particularly large for firms that employ low-wage workers and experience frequent layoffs, such as construction and manufacturing companies. Furthermore, the increases in debt financing yield significant tax savings for firms, due to the tax deductibility of interest payments.