Abstract

۱٫ INTRODUCTION

۲٫ THE CONCEPTUAL FRAMEWORK AND HYPOTHESIS DEVELOPMENT

۳٫ MAIN VARIABLES, SAMPLE CONSTRUCTION, AND DESCRIPTIVE STATISTICS

۴٫ EMPIRICAL TESTS ON THE LINK BETWEEN INVESTMENT

RISKINESS AND AVERAGE EMPLOYEE PAY

۵٫ CHANNELS OF INVESTMENT RISK

۶٫ LABOR INTENSITY’S FEEDBACK EFFECT

۷٫ CONCLUSION

ACKNOWLEDGMENTS

ENDNOTES

REFERENCES

Abstract

     In this paper, we examine the link between human capital cost and investment policy. We find a significantly positive relationship between investment risk and the cost of human capital measured by average employee pay, especially when employees have strong bargaining power. We further investigate various channels through which investment risk influences human capital cost and find strong empirical support that these channels are important drivers. Our results suggest that a higher human capital cost associated with an increase in investment risk discourages firms from making valuable but risky investments in the future, leading to a potential problem of underinvestment.

Introduction

     An aggressive investment policy is often associated with high business risk: if successful, it benefits the firm in the long run; if not, it may hasten business failure. The literature identifies one of the causes of corporate failure, as summarized in Argenti (1976), as insufficient consideration of research and development (R&D) costs. Dambolena and Khoury (1980) show that firms with a substantial degree of instability, measured by the standard deviation of financial ratios, have a higher likelihood of bankruptcy than those with a low degree of instability. For bankrupt firms, the degree of instability increased significantly over the period leading up to corporate failure.1 When large investments fail, the firm faces a high possibility of operating losses, which ultimately leads to cessation of operations. Thus, investment risk is undeniably one of the most important determinants of business failure.

At the same time, the literature on labor economics (e.g., Clark, Georgellis, & Sanfey, 2001; Clark & Oswald, 1994) shows that employees’ fear of job loss is a major concern, regardless of whether a replacement job is obtainable. The more aggressive a firm’s investment policy is, the riskier the firm, and hence the higher the risk of the human capital loss borne by employees. The labor market literature also shows that employees can gain bargaining power against their employers with outside job opportunities (Campbell, Ganco, Franco, & Agarwal, 2012; Lewis & Yao, 2001; Smith, 2006) and in the presence of labor unions (Hendricks, 1994). With bargaining power, rational employees may be able to demand a higher wage to compensate for the risk of human capital loss associated with corporate investment policies. More specifically, more aggressive investment activities may be linked to higher human capital costs. This conjecture has important implications for firms. If human capital costs increase as the risk of an investment project increases, the expected future cash flows decrease, assuming that the initial cash outlay remains relatively flat.

Results and analyses

     The recent literature has started to shed more light on the role of human capital costs in influencing corporate policies. In this paper, we conjecture that employees bear large human capital losses from a firm’s risky investments. In a theoretical framework, we present the risk borne by the firm and its employees arising from a decision to engage in risky investments. We empirically examine the relationship between investment risk and human capital cost. Our findings support a strong and positive relationship between human capital cost and investment risk. More specifically, using two measures of investment risk—cash-flow volatility and unlevered stock return volatility—we find that investment risk is significantly positively correlated with average employee pay. The positive relationship is both statistically and economically significant. For example, for every one-standard deviation increase in cash flow volatility, the average employee pay increases by 14.07%. We further show that firms with employees who have more bargaining power exhibit a stronger relation between investment riskiness and average employee pay. Our results remain robust after various tests for endogeneity.

The link between investment riskiness and human capital cost may be driven by various policy channels resulting in investment risk. We explore four possible channels for investment riskiness: corporate diversification, R&D expenditures, advertising expenditures, and acquisition amounts. We find support for a significant relation between each of the channels and human capital cost. In particular, we find that a firm’s R&D expenditures, advertising expenditures, and acquisition amounts are positively related to human capital cost, while diversification level is negatively related. Lastly, we explore the possible feedback effect of an increased human capital cost on a firm’s investment policy