In an economy with perfectly competitive capital and labor markets, we derive the optimal labor contract for firms with both equity and debt, and show that it implies employees will become entrenched and therefore face large human costs of bankruptcy. The firm’s optimal capital structure emerges from a trade-off between these human costs and the tax benefits of debt. Our model delivers optimal debt levels consistent with those observed in practice without relying on frictions such as moral hazard or asymmetric information. In line with existing empirical evidence, our model implies persistent idiosyncratic differences in leverage across firms, and shows that wages should have explanatory power for firm leverage.
Ever since Modigliani and Miller (1958) first showed that capital structure is irrelevant in a frictionless economy, financial economists have puzzled over exactly what frictions make the capital structure decision so important in reality. Over the years a consensus has emerged that at least two frictions are important: corporate income taxes and bankruptcy costs.
An interesting characteristic of capital structure research is the apparent disconnect between the costs of bankruptcy identified in the academic literature and those discussed in the popular press. During a corporate bankruptcy, the press almost invariably focuses on the human costs of bankruptcy. This focus can be explained by research in psychology that demonstrates that job security is one of the most important determinants of human happiness and that the detrimental effect on happiness of an involuntary job loss is significant. Yet these human costs of bankruptcy have received minimal attention in the corporate finance literature. It is not difficult to understand why. Intuitively, if employees are being paid their competitive wage, it should not be very costly to find a new job at the same wage. Thus, for substantial human costs of bankruptcy to exist, employees must be entrenched; they must incur costs associated either with not being able to find an alternative job, or with taking another job at substantially lower pay. However, such entrenchment seems difficult to reconcile with optimizing behavior: Why do shareholders overpay their employees, especially at times when the firm is facing the prospect of bankruptcy?
In this paper we argue that this intuition is wrong. In fact, entrenchment is an optimal response to labor market competition. In an economy with perfectly competitive capital and labor markets, one should expect employees to face large human costs of bankruptcy. Moreover, consistent with anecdotal evidence, these indirect costs of bankruptcy are large enough to impose significant limits on the use of corporate debt.
ur results extend the insights of Harris and Holmström (1982). In a setting without bankruptcy, debt or limited liability equity, that paper shows that the optimal employment contract between a risk-averse worker and a risk-neutral equity holder guarantees job security (employees are never fired), and pays employees a fixed wage that never goes down but rises in response to good news about employee ability. The intuition behind this result is that while employees are averse to their own human capital risk, this risk is idiosyncratic so equity holders can costlessly diversify it away. Optimal risk sharing then implies that the shareholders will bear all of this risk by offering employees a fixed wage contract; however, employees cannot be forced to work under such a contract because employees who turn out to be better than expected will threaten to quit unless they get a pay raise. This threat leads to the optimal contract derived by Harris and Holmström (1982).
Our first contribution is to derive the optimal compensation contract in a setting that includes both (limited liability) equity and debt. We find that the optimal employment contract in this setting is similar to that in Harris and Holmström (1982): Unless the firm is in financial distress, wages never fall, and they rise in response to good news about employee productivity; however, unlike Harris and Holmström (1982), if the firm cannot make interest payments at the contracted wage level, the employee takes a temporary pay cut to ensure full payment of the debt. If the financial health of the firm improves, wages return to their contracted level.
If the firm deteriorates further, so that it cannot make interest payments even with wage concessions, it is forced into bankruptcy. In bankruptcy, it can abrogate its contracts, and employees can be terminated and replaced with more productive employees. Because contracted wages never fall in response to bad news about employee productivity, employees’ wages at the moment of termination will typically be substantially greater than their competitive market wages. As a result, these entrenched employees face substantial costs resulting from a bankruptcy filing; they will be forced to take a wage cut and earn their current market wage.
