ABSTRACT An employee's annual earnings fall by 13% in the first full calendar year after her firm's bankruptcy, and the present value of lost earnings from bankruptcy to six years following bankruptcy is 87% of pre‐bankruptcy annual earnings. More worker earnings are lost in thin labor markets and among small firms. Ex ante compensating wage differentials for this “bankruptcy risk” are up to 2% of firm value for a firm whose credit rating falls from AA to BBB, comparable in magnitude to debt tax benefits. Thus, wage premia for expected costs of bankruptcy are sufficiently large to be an important consideration in capital structure decisions.
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