Labour leverage, equity risk and corporate policy choice

Abstract

This paper investigates the role of labour utilization in assessing equity investment risk and corporate financial policy choices. Several existing models of the firm predict that labour utilization is costly to adjust in the short run. I argue that this leads to a relatively fixed obligation to pay cash to labour, in effect creating an off-balance-sheet intangible liability similar to a lease. The liability creates 'labour leverage' risk, analogous to financial leverage risk. Labour leverage is hypothesized to be positively correlated with equity investment risk as measured by characteristics of stock returns. Managers recognize this risk and adjust financial policies including debt financing and dividend policy accordingly. The main empirical results are that labour leverage is positively correlated with equity investment risk, and it plays the predicted role in regressions explaining financial structure and dividend policy. Proxies for labour leverage are simple measures based on existing disclosure. The results are consistent with the conjectures that market participants use labour disclosures to assess risk, and that managers take actions to mitigate this risk. The results are consistent across most sectors of the economy, and consistent over time.

Labor Unions, Operating Flexibility, and the Cost of Equity

“…Our primary measure of operating leverage is MRDOL. We also use LS, which Rosett (2003) argues is a proxy for a firm's committed labor expenses and thus may be related to equity risk. Table 12 presents the results in which we sequentially add the measures of operating leverage to our base specification.…”

Accounting for Investments in Human Capital: A Review

“…A key issue for employers is the existence of a continuing obligation to hire the workers as long as the firm continues to exist and operate. The obligation to maintain a workforce gives rise to operating leverage effects, due to the fixed commitment to pay compensation to workers, and financial risk implications for the firms’ financing policies (Rosett 2003). Consistent with operating leverage (due to human capital costs) contributing to the firms’ operating risk profile, a number of studies suggest that the firms’ level of human capital investment decreases as the riskiness of the firms’ return on investment increases (for example, Osterman 1994).…”

“…In particular, labour is costly to adjust in the short run, and Rosett (2003) argues that consequently the firm has a present and continuing obligation to pay compensation to labour, thereby creating an off‐balance‐sheet intangible liability similar to a lease. Rosett (2003) labels the liabilities labour leverage (measured as total employment deflated by the market value of equity) and labour cost leverage (measured as compensation costs deflated by the market value of equity). He finds these leverage measures are positively correlated with the firms’ equity risk, and negatively correlated with leverage and dividend payouts.…”

Analysts’ Perceptions of Intellectual Capital Information

“…There are also studies showing that human capital‐intensive firms and firms investing heavily in employee training are under‐priced by the market (Bassi, Harrison, Ludwig and McMurrer 2004; Hansson 1997). Similarly, other measures of human capital such as labour compensation have been shown to be associated with both risk and return of specific stocks, as well as excess returns (Jagannathan, Kubota and Takehara 1998; Rosett 2000; Rosett 2003; Hansson 2004). While the pricing of IC‐intensive firms appears to be a difficult issue, there seems to be little difference in the prospects of initial public offerings (IPOs) with regard to disclosure of IC in Japan.…”