Labor Adjustment Costs and Capital Structure Decisions

This paper investigates how the costs associated with dismissing employees impact a firm’s capital structure decisions. I hypothesize that increases in these labor adjustment costs reduce a firm’s optimal amount of debt financing by lowering expected profitability and raising financial distress costs and operating leverage. To test this hypothesis, I adopt a difference-in-differences research design and exploit the passage of state-level wrongful discharge laws that allow workers to sue employers for unjust dismissal as an exogenous increase in labor adjustment costs. I find robust evidence that firms reduce financial leverage ratios following the passage of these laws. This finding is driven by firms whose employees are more likely protected by these laws, firms whose employees are more likely to file wrongful termination lawsuits, and firms that are more likely to lay off workers. Additional analyses suggest that reverse causality and omitted variables related to local economic conditions, changes in the types of workers that a firm employs, and changes in the nature of a firm’s operations do not drive these results. Lastly, firms also hold more cash and investors place a higher value on each additional dollar of cash holdings following the passage of wrongful discharge laws. Overall, my findings imply that labor market frictions in the form of labor adjustment costs can have a significant impact on a firm’s financing decisions. * Matthew Serfling is from the Department of Finance, University of Arizona, Tucson, AZ., 85721 and can be reached at [email protected] and 520-621-7554. I am grateful for the helpful suggestions from my dissertation committee members, Sandy Klasa (chair), Kathleen Kahle, Hernán Ortiz-Molina, Ryan Williams, and Tiemen Woutersen. I would also like to thank Douglas Fairhurst, Svetlana Orlova, Shweta Srinivasan, conference participants at the 2013 Financial Management Association Annual Meeting, and workshop participants at the University of Arizona for their helpful comments.