DP15819 Employment Flexibility and Capital Structure: Evidence from a Natural Experiment

Author(s): Olga Kuzmina
Publication Date: February 2021
Keyword(s): Capital Structure, Fixed-term contracts, Operating flexibility, Operating Leverage
JEL(s): D22, G32, J41
Programme Areas: Labour Economics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15819

Exploiting the variation in labor-market programs in Spain, I show that the use of flexible (shorter and cheaper-to-fire) employment contracts increases a firm's debt capacity. A thought experiment of prohibiting an average firm from hiring workers on flexible contracts suggests that such a firm should reduce its debt-to-capital ratio by 7%. I further nail down the employment flexibility mechanism behind this effect, which works through reductions of the firm's operating leverage and the fixity of its costs. I use specific institutional features to separate this explanation from differences in wages or labor bargaining power. I show that the effects are stronger for firms suffering most in bankruptcy and that in downturns, firms downsize using flexible labor, implying that the employment-contract structure is a significant component of operating flexibility and expected default costs. Finally, employment flexibility increases firm value for firms that benefit most from operating leverage reductions and depend more on external financing. The results demonstrate how management can use heterogenous labor contracts to improve firm outcomes. Most broadly, the results emphasize the importance of studying operating strategy and organizational structure as integral determinants of the financing decisions of firms and highlight the complementarities between CEOs' and CFOs' decision-making.