Capital Structure as a Strategic Variable

This post comes to us from David Matsa of the Kellogg School of Management, Northwestern University.


The standard corporate finance paradigm posits that a firm determines its optimal capital structure by making tradeoffs between the tax advantages of debt, the expected costs of financial distress, the impact of asymmetric information, and the implications for managerial incentives. But when financial policy affects a firm’s competitive position in product or input markets, the firm has an incentive to set its capital structure strategically to influence the behavior of competitors, customers, or suppliers. Although this argument is well understood in theory, its empirical relevance is much less clear. My forthcoming Journal of Finance paper, Capital Structure as a Strategic Variable: Evidence from Collective Bargaining, fills an important gap by showing that strategic incentives from labor markets have a substantial impact on financing decisions.

Delta Air Lines’ recent experience exemplifies how too much flexibility can hurt a firm’s bargaining position with workers. With a strong market position and a history of fiscally conservative management, Delta weathered the airline industry downturn after September 11, 2001 by building up cash and liquidity. But greater liquidity also reduced the need to cut costs and hurt Delta’s bargaining position with workers (Perez (2004)). By 2004, Delta found itself far behind the other big carriers in restructuring, and in severe financial distress.

I begin my analysis through a theoretical framework that illustrates how collective bargaining affects a firm’s optimal debt policy. This framework shows that collective bargaining interacts with variability in a firm’s profits to give the firm a strategic incentive to increase its debt. The firm must consider the tradeoff between gains from improved bargaining power when the cash flow shock is positive and losses from increased costs of financial distress when the shock is negative. Greater profit variability has an asymmetric impact on this tradeoff, because the union earns rents only on inframarginal realizations of the shock. While greater variability exposes unionized and nonunionized firms to similar costs in periods of financial distress, it increases liquidity and hence a unionized firm’s exposure to union rent seeking when a cash flow shock is positive. Thus, a unionized firm with high profit variability has greater strategic incentive to use debt to shield liquidity from workers in bargaining and thus a higher optimal debt ratio than an otherwise similar nonunionized firm.

I then provide empirical evidence for the strategic use of debt using two estimation strategies. In the first approach, I analyze cross-sectional correlations between debt and the percentage of employees covered by collective bargaining (a direct measure of union power) for a sample of mostly manufacturing firms from the 1970s, 1980s, and 1990s. The results suggest that union bargaining power leads firms to increase financial leverage: on average, the ratio of debt to firm value is 80 to 110 basis points higher when an additional 10% of employees bargain collectively. According to these estimates, a firm with a 50% unionized workforce is associated with 15% to 20% greater financial leverage than a typical nonunionized firm. Furthermore, these differences are larger at firms with more variable profits. However, this result may be affected by omitted variable bias: unions are more likely to organize in established, profitable firms and industries, which may also have a greater capacity for debt.

To overcome this problem, I employ a second empirical approach, which uses states’ adoption of right-to-work laws in the 1950s and states’ repeal of unemployment insurance work stoppage provisions in the 1960s and early 1970s as sources of exogenous variation in union power. I find that after states adopt legislation to reduce union bargaining power, firms with concentrated labor markets reduce debt relative to otherwise similar firms in other states. In fact, the ratio of debt to firm value decreases by up to one-half after a right-to-work law is passed. These effects are again linked to variability in firm profits. While the ratio of debt to firm value decreases by up to one fifth after a work stoppage provision is repealed for firms with profit variability that is one standard deviation above the mean, there is little effect among firms with low profit variability. As a falsification test, I show that these changes in labor laws do not seem to affect financial policy at firms in industries with low union presence. Various tests confirm the robustness of the profit variability interaction.

The full paper is available for download here.

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