Labour leverage, equity risk and corporate policy choice

Joshua Rosett

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Corporate Finance and Governance Auditing, Earnings Management, Governance Financial Analysis and Corporate Governance

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.

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References

1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*1992The Cross-Section of Expected Stock Returns 1973Risk, Return, and Equilibrium: Empirical Tests 2019American Economic Review 1965The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets 1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]1995What Do We Know about Capital Structure? Some Evidence from International Data 1988The Determinants of Capital Structure Choice

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