Outside Employment Opportunities, Employee Productivity, and Debt Disciplining

Jayant R. Kalea, Harley E. Ryan, Jr.a, Lingling Wangb

a
Department of Finance, J. Mack Robinson College of Business, Georgia State University,
Atlanta, GA 30303, USA
b
A.B. Freeman School of Business, Tulane University,
New Orleans, LA 70118, USA

This version: October 13, 2010

Abstract

We analyze how changes in labor market conditions influence the effect of a firm’s debt policy
on its employee productivity and value. We first establish that debt in the capital structure
increases the productivity of the firm’s employees and then show that this positive productivity-
leverage relation becomes weaker when outside employment opportunities for employees
improve. We also find that the passage of NAFTA, an exogenous shock to employment
opportunities in the manufacturing industry, weakened the positive productivity-leverage relation
for manufacturing firms. These effects are economically significant, and second only to the
influence of asset intensity in magnitude.

JEL classification: G30; G32; G38

Keywords: Debt Disciplining, Agency Theory, Outside Employment Opportunities, Employee Productivity

Contact info for Kale: +1 404 413 7345 and jkale@gsu.edu, for Ryan: +1 404 413 7337 and cryan@gsu.edu, and for
Wang: +1 504 865 5044 and lwang1@tulane.edu. Kale acknowledges support from the H. Talmage Dobbs, Jr.
Chair. We thank Vikas Agarwal, Rajesh Aggarwal, Thomas Bates, Bruce Carlin, Yongqiang Chu, Alex Edmans,
Cheol Eun, Lorenzo Garlappi, Gerry Gay, Shingo Goto, Denis Gromb, Atul Gupta, Dirk Hackbarth, Kathleen Weiss
Hanley, Iftekhar Hasan, Jean Helwege, Kose John, Marcin Kacperczyk, Simi Kedia, Omesh Kini, Kai Li, Tanakorn
Makaew, Steven Mann, Ron Masulis, Bill Megginson, George Morgan, Gordon Phillips, Josh Pierce, Eric Powers,
Nagpurnanand Prabhala, Charu Raheja, Michael Rebello, Husayn Shahrur, Lemma Senbet, Steve Smith, Sergey
Tsyplakov, Chuck Trzcinka, Vahap Uysal, Anand Venkateswaran, Xiaoyun Yu, Donghang Zhang, and seminar
participants at Georgia State University, Florida International University, Indian School of Business, University of
South Carolina, University of South Florida, Corporate Finance Conference at Universitè Paris – Dauphine, 18th
Conference on Financial Economics and Accounting at New York University, the Financial Management
Association Meetings in Orlando, FL, and the Steve Smith Memorial Conference at the Federal Reserve Bank of
Atlanta for comments. We thank the Bureau of Labor Statistics for providing some of the data used in our analysis.
We alone are responsible for remaining errors.
 Outside Employment Opportunities, Employee Productivity, and Debt Disciplining

1. Introduction

By some estimates, the North American Free Trade Agreement (NAFTA) resulted in a

decrease of more than 879,000 actual and potential jobs between 1994 and 2002; mostly in the

manufacturing sector (Scott, 2003). Although the net merits of NAFTA are still under debate, it

is clear NAFTA affected the actual and perceived employment opportunities and the mobility of

management and workers in certain industries. In light of such potentially large changes in

employment opportunities, we seek to answer a basic empirical question: How do changes in (or

shocks to) labor markets impact the efficacy of a firm’s financial policies? Specifically, we

analyze the effects of changes in outside employment opportunities (including those arising from

the passage of NAFTA) on the influence of a firm’s debt policy on its productivity and,

consequently, its value.

Our research is motivated by the insights provided by two strands of literature. One

strand consists of theoretical and empirical studies that propose and document relations between

capital structure and conditions in the labor market.1 The second strand emanates from the

seminal papers by Grossman and Hart (1982) and Jensen (1986), which demonstrate that risky

debt serves as a costly disciplining mechanism to reduce the agency costs that arise from the

separation of ownership and control. Our paper spans these two areas by examining how

changes in employment opportunities in the labor market affect the disciplining role of debt.

The rationale underlying the disciplining role of debt is that the presence of risky debt in

the firm’s capital structure introduces the possibility that the firm goes bankrupt. The manager of
1
For the effect of labor markets on capital structure, see Bronars and Deere (1991), Perotti and Spier (1993),
Dasgupta and Sengupta (1993), Hanka (1998), Chen, Kaperczyk, and Ortiz-Molina (2009a, 2009b), Matsa (2010),
and Berk, Stanton, and Zechner (2010).
 2

the firm receives benefits/payoffs that relate positively to firm value in non-bankrupt states but

bears significant personal costs in the event the firm goes bankrupt. In this setting, debt provides

the manager an incentive to increase his effort, which reduces the likelihood of bankruptcy and

results in higher firm value.

We hypothesize that this disciplining role of debt becomes weaker if agents have

alternative employment opportunities. The agent will optimally choose to accept a job in another

firm if the cost of changing employers is lower than the disutility of extra effort and expected

personal bankruptcy costs associated with a higher debt level in the current firm.2 Thus, the

disciplinary role of debt will be weaker when the agent has more outside employment

opportunities. We examine a sample of more than 105,000 firm-years from 1976 to 2007 and

find strong support for the disciplining role of debt and our hypothesis that better outside

employment opportunities reduce the efficacy of debt as a disciplining mechanism. To our

knowledge, our study is the first large-sample examination of debt as a disciplining mechanism

and also the first to incorporate explicitly outside employment opportunities into the analysis.

Grossman and Hart (1982) and Jensen (1986) demonstrate that risky debt acts as a

disciplining tool for top managers. However, for several reasons, we relate the presence of debt

levels to the productivity of all the employees in the firm. First, the actions of top management

are generally not observable to the outsider, but total employee productivity is a measurable

outcome that is highly correlated with managerial effort. The following quotation from Brealey,

Myers, and Allen (2006, p. 10) amply illustrates the logic underlying this correlation.

Conflicts between shareholders and managers are not the only principal-agent
problems that the financial manager is likely to encounter. For example, just as

2
The presence of debt may also reduce the ability of the manager to consume perks and/or invest in “pet” projects,
and increase the disutility from additional monitoring. See, for instance, Stulz (1990).
 3

shareholders need to encourage managers to work for the shareholders’ interests,

so senior management needs to think about how to motivate everyone else in the
company. In this case, senior management are the principals and junior
management and other employees are the agents.

It follows that top managers direct much of their effort towards making other employees more

productive.3 Debt provides top management with the incentive to exert more effort to closely

monitor middle managers, who then expend greater effort to monitor lower-level employees, and

so on down the corporate hierarchy. Thus, total employee productivity should be highly

correlated with top management effort.

Second, since CEOs are likely to lose their jobs when their firms experience financial

distress (Gilson, 1989, 1990; Gilson and Vetsuypens, 1993), they have a strong incentive to take

preemptive actions such as layoffs, which result in job losses for lower-level employees.

Consistent with this view, Sharpe (1994) shows that the cyclicality of the labor force in

manufacturing firms is positively related to financial leverage. So, higher debt should have a

direct effect on the productivity of all firm employees since the possibility of financial distress

creates job-loss concerns for all the employees of a firm. In summary, employee productivity is

observable and correlated with top management effort, much of which is directed towards

making other employees more productive. Moreover, debt imposes costs on all employees

providing an incentive to both management and labor to increase their effort and productivity.

For these reasons, we use employee productivity to measure the disciplining influence of debt.

To test our hypothesis that better outside employment opportunities reduce the efficacy of

debt as a disciplining mechanism, we examine the influence of changes in outside employment

opportunities on the relation between employee productivity and leverage. We use three

3
Studies indicate that top management spends from about 50% to as much as 64% of their time in verbal contact
with subordinates. See Kurke and Aldrich (1983) for a summary of the evidence.
 4

measures of industry-level outside employment opportunities: (i) the voluntary quit rate (the

proportion of employees in an industry that voluntarily quit their jobs) (ii) the hire rate (the

number of new hires in an industry divided by total employees in the industry) and (iii) the rate

of growth in unemployment in the firm’s industry. In addition to these industry-specific

variables, we also use the passage of the NAFTA in 1994 as an exogenous shock to employment

opportunities in the manufacturing sector.4

We examine a panel data set of 105,704 firm-years encompassing more than 13,800 firms

from 1976 – 2007. Consistent with the debt disciplining hypothesis, we find a significantly

positive relation between employee productivity and financial leverage. Further, the findings for

all of the outside employment opportunity proxies tell a consistent story: When outside

employment opportunities increase (decrease), the relation between employee productivity and

debt is significantly weaker (stronger). When an exogenous event such as NAFTA reduced the

employment opportunities for employees, we find that the relation between productivity and

leverage became stronger. In addition, since NAFTA predominantly reduced the employment

opportunities in the manufacturing sector, we find that the passage of NAFTA strengthened the

disciplining role of debt primarily in the manufacturing sector. Taken together, our empirical

findings strongly support the hypothesis that debt serves as a costly disciplining mechanism and

that greater outside employment opportunities reduce the effectiveness of this disciplining

mechanism.

Our findings are robust to a variety of econometric approaches, specifications, and tests

to rule out alternative explanations for our results. We also show that our results hold when we

control for unobserved industry effects and potential endogeneity of both leverage and outside

4
Scott (2001, 2003) and Hottenrott and Blank (1998) present evidence that NAFTA resulted in significant job losses
and affected job opportunities primarily in the manufacturing sector.
 5

employment opportunities. Our results also obtain when we estimate an industry-level

regression, include year and industry fixed effects, use an alternative measure of employee

productivity based on cash flow, specify a quadratic function that allows for a nonlinear relation

between productivity and leverage, estimate over different time periods, use multiple methods to

control for the influence of mergers and acquisitions, exclude the top and bottom deciles by

number of employees or the top quartile of firms by leverage, and include firms with no debt in

their capital structures.5

To illustrate the economic significance of our results, we estimate how changes in the

level of employment opportunities at different debt levels impact imputed firm value, which we

compute as the product of the employee productivity in the firm and the median ratio of value to

productivity for the firm’s industry. Our hypotheses relate to the effect of leverage on

productivity and since imputed firm value is computed directly from firm productivity, it enables

us to assess the economic significance of our variables of interest without the confounding

effects of other variables that may impact firm value through leverage (e.g., debt tax shields).

Complementing our results for labor productivity, we find (i) an overall positive relation between

imputed firm value and debt level, and (ii) lower imputed value from debt disciplining when

there are more outside employment opportunities. Our analysis indicates that only asset intensity

has a greater impact than leverage on employee productivity and firm value.

Our finding of a positive relation between employee productivity and financial leverage

adds to the empirical evidence on the disciplining role of debt. Most existing studies in this area,

however, focus on firms that are targets of leveraged buyouts or engage in highly levered

recapitalizations. Although these studies offer support for the disciplining role of debt, the

5
Researchers (e.g., Gardner and Trzcinka, 1992 and Strebulaev and Yang, 2006) show that firms with no debt may
be systematically different from leveraged firms.
 6

sample sizes in these studies are rather small since firms seldom conduct such highly-leveraged

recapitalizations.6

More broadly, our finding that greater outside employment opportunities weaken the

relation between employee productivity and financial leverage adds to our understanding of how

financial policies interact with nonfinancial markets. In support of the debt-disciplining

hypothesis, Phillips (1995) finds that inefficient output in the product markets declines following

leveraged recapitalizations. Hanka (1998) and Matsa (2010) show that financial leverage can be

used as a strategic tool to negotiate with labor, and Chen, Kaperczyk, and Ortiz-Molina (2009a,

2009b) find that labor unions affect a firm’s cost of capital. Our findings complement this

literature by showing that the employment conditions in labor markets influence the efficacy of

debt disciplining. At a general level, our study also contributes to the literature that examines

how a firm’s capital structure reflects the influence of both financial and non-financial

stakeholders, which include suppliers, customers and labor.7

Our finding that more outside employment opportunities weaken the ability of debt to

discipline the agents of the shareholders complements research on how employment

opportunities affect firms’ attempts to mitigate agency problems. For instance, Cappelli and

Chauvin (1991) provide evidence that fewer alternative employment opportunities result in fewer

incidences of employee shirking; Parrino (1997) provides evidence that outside employment

opportunities influence the decision to fire and hire CEOs; and consistent with Oyer’s (2004)

6
Kaplan (1989), Lehn and Poulsen (1989), Marais, Schipper, and Smith (1989), Lehn, Netter, and Poulsen (1990),
Muscarella and Vetsuypens (1990), Smith (1990), Opler (1992), Opler and Titman (1993) and Denis and Denis
(1993) are studies that investigate the disciplining role of debt.
7
See, for instance, Titman (1984), Brander and Lewis (1986), Maksimovic (1988, 1990), Chevalier (1995),
Kovenock and Phillips (1995, 1997), Campello (2006), and Kale and Shahrur (2007).
 7

theory, Rajgopal, Shevlin, and Zamora (2006) document that outside employment opportunities

influence the structure of CEO incentive compensation.

The rest of the article is organized as follows. The next section describes our data

sources and the variables we use in the analysis. Section 3 discusses our empirical method.

Section 4 presents our primary empirical findings, and Section 5 presents results from robustness

tests. The last section concludes.

2. Data, variable construction and summary statistics

2.1. Data

Our initial sample includes all firms in the Compustat Industrial Annual database from

1976 to 2007. We obtain stock returns from the Center for Research in Securities Prices (CRSP)

database and accounting data from the Compustat database. We exclude ADRs, financial (SIC

codes 6000 to 6999) and utility firms (SIC codes 4900 to 4999). We also exclude firms with

sales or asset growth rates of more than 200% a year since such high growth usually signals

merger or acquisition activities that could affect employee productivity and financial leverage

(see Campello, 2006).8 Because financially distressed firms tend to perform poorly (e.g. Opler

and Titman, 1993), we also exclude firms with debt ratio in the top debt decile of our sample

(debt ratio above 0.658).9 Strebulaev and Yang (2006) find that zero-debt firms are smaller, more

profitable, and have higher dividend payout ratios and cash balances than industry-matched firms

with debt. Firms with high growth opportunities may also optimally carry no debt to avoid the

Myers (1977) debt overhang problem (Gardner and Trzcinka, 1992). Thus, we exclude zero-debt

firms from our main tests, but verify that our results hold if we include zero-debt firms.

8
As an alternative, we repeat all tests on a sample in which we exclude firm-years in which firms reported M&A
sales impact in the income statement, and find similar results.
9
Our results are robust if we exclude firms in the top debt quartile. As another check, we include firms in the top
leverage decile and estimate a quadratic leverage model to show the appropriateness of the sample restriction.
 8

We use data from the Job Opening and Labor Turnover (JOLT) Survey and the Current

Population Survey (CPS) provided by the Bureau of Labor Statistics (BLS) to compute measures

of outside employment opportunities (quit rate, hire rate, and unemployment growth rate). The

JOLT survey provides data on the quit rate and hire rate from 2000 and covers all nonagricultural

industries.10 The CPS survey provides data on the unemployment rate from 1976 and covers all

industries. In our tests, we adjust variables by subtracting their respective industry medians or

by including dummy variables to control for industry effects. To be consistent with the industry

definitions from the JOLT survey, we report results based on two-digit SIC codes. However, our

results are robust if we use three-digit SIC codes.

We require a minimum of 5 firms in the firm’s 2-digit SIC code11 and require that the

firm have at least 30 days return data in CRSP daily stock returns database and information on

number of employees, total assets, debt, sales and profitability in Compustat. We use the

Consumer Price Index (CPI-U) compiled by the BLS to adjust dollar values to 2003-dollar

levels. To control for the influence of extreme values, we winsorize firm-level variables by

setting values that exceed the 99th percentile or fall below the first percentile to the 99% and 1%

values, respectively. Our final sample consists of 105,704 firm-years for 13,886 firms and the

number of firms ranges from 2,434 to 4,483 per year over the sample period.

2.2 Variable Construction

2.2.1 Outside Employment Opportunities

We use three measures of changes in outside employment opportunities: (1) Quit Rate by

industry; (2) Hire Rate by industry, (3) Industry Unemployment Growth Rate. In addition, we

10
The BLS also provides quit rates from 1970 to 1981. However, since these data cover only the manufacturing
industry and are not directly comparable with the JOLTS data, we use the quit rates and hire rates from JOLTS data.
11
We obtain similar results for a sample that requires a minimum of ten firms in an industry. Since historical SIC
codes are available in Compustat only from 1987, we use the 1987 historical SIC code for years prior to 1987.
 9

investigate the effect of NAFTA, an exogenous shock to employment opportunities, on the

leverage-productivity relation.

The BLS defines Quit Rate as the number of employees who leave their jobs voluntarily

(except retirements or transfers within the same firm) divided by the total number of employees

in the industry in a survey year. The Hire Rate is the number of new hires in the industry during

the annual survey period divided by the number of employees in the industry over the same

period. A higher value of Quit Rate generally implies better outside employment opportunities

for employees in that industry. It is conceivable that the Quit Rate may be higher also if

employees voluntarily quit their jobs to pursue opportunities in other industries if there is a

downturn specific to an industry. The Hire Rate, however, does not suffer from this problem.

The Quit Rate and Hire Rate are available from 2000 through 2007 for 2-digit SIC code industry

classifications. Our third measure of outside employment opportunities is the Unemployment

Growth Rate, which is the ratio of current year’s unemployment rate in an industry divided by

the previous year’s unemployment rate in that industry minus one. The unemployment growth

rate measures the negative marginal change in industry employment opportunities.12 We use the

change in unemployment and not the level of unemployment since, in equilibrium, debt and

effort levels will already reflect unemployment levels.

We also investigate the effect of an exogenous shock to employment opportunities, the

passage of NAFTA in 1994, on the leverage-productivity relation. Scott (2003) estimates that

from 1994 through 2002, the increase in the trade deficit with Canada and Mexico resulting from

NAFTA “caused the displacement of production that supported 879,280 jobs.” To examine the

12
The CPS Survey in BLS provides unemployment rates for two-digit SIC codes before 2002 and three-digit
NAICS codes after 2002. We assign the unemployment rate to a firm based on its 2-digit SIC industry code before
2002 and 3-digit NAICS industry code after 2002.
 10

effect of an exogenous shock to employment opportunities due to the implementation of

NAFTA, we create a dummy variable, NAFTA, which equals zero if the firm-year is before 1994

and one if the firm-year is 1994 or later. Moreover, research (Scott, 2001, 2003; Hottenrott and

Blank, 1998) shows that the passage of NAFTA affected job opportunities primarily in the

manufacturing sector, so we conduct tests on subsamples of firms in manufacturing and non-

manufacturing sectors.

2.2.2 Employee Productivity and Imputed Firm Value

Our primary measure of firm-level employee productivity, Output per Employee, is the

ratio of firm output to the number of employees (data item 29) in the firm. We follow Schoar

(2002) and Brynjolfsson and Hitt (2003) and measure the firm’s output as sales (Compustat data

item 12) plus changes in inventories (work in progress, data item 77 and finished goods, data

item 78). Our results are robust to using a value-added productivity measure, EBITDA per

employee. To examine the economic significance of the influence of leverage on productivity,

we construct Imputed Firm Value, which is a measure of firm value based on employee

productivity. We compute Imputed Firm Value as follows. For each firm-year, we first compute

the firm value as the sum of market value of equity (data item 25*data item 199) and the book

value of debt (data item 9 plus data item 34) and divide firm value by Output per Employee to

obtain an estimate of the firm value per unit of productivity. We define the median value of this

firm value per unit of productivity in the two-digit industry as our industry valuation multiplier

for all firms in that industry. For each firm-year, Imputed Firm Value is the product of its Output

per Employee and the industry valuation multiplier. The advantage of using Imputed Firm Value

rather than the firm’s market value is that changes in Imputed Firm Value reflect value increases
 11

induced only by changes in productivity whereas firm value changes may arise from other

sources such as debt tax shields or changes in growth opportunities.

2.2.3 Leverage

We measure Leverage as the book value of long-term debt plus debt in current liabilities

(data item 9 + data item 34) divided by book value of debt plus the market value of equity (data

item 9 + data item 34 + data item 25*data item 199). For robustness, we repeat all our tests with

Leverage computed using the book value of equity and obtain similar results.

2.2.4 Control Variables

We control for a number of other factors that may also influence productivity. Consistent

with a Cobb-Douglas production function, we include the number of employees (date item 29) as

a proxy for labor input, and following Hanka (1998), compute Asset Intensity, capital inputs per

employee, as total assets (data item 6) divided by the number of employees. To control for the

possibility that productivity increases along a learning curve as firms mature, we include the

variable Firm Age, which is the number of years a firm has been in the Compustat Annual

database. Since the Compustat database contains data on firms dating to 1950, the maximum

value of Firm Age for firms in our sample is 57 years. We control for the possibility that

operating leverage can influence productivity with the variable Operating Leverage, which is the

ratio of gross property, plant & equipment (data item 7) to total assets.13 To control for the

effects of product market competition (Jensen, 1986; Maksimovic, 1988; Philips, 1995; Mackay

and Philips, 2005), we assign to every firm in an industry that industry’s Herfindahl Index (HHI),

which is the sum of the squared market share of each firm in that industry.

13
We obtain similar results if we use net property, plant & equipment divided by total sales.
 12

2.2.5 Descriptive Statistics

We present summary statistics for the sample in Panel A of Table 1. Summary statistics

for our primary test variables – leverage, employee productivity measures, and outside

employment opportunities – are in the top portion of Panel A. Since data from the BLS are

available only from year 2000, the sample size declines from 105,704 firm-years for Leverage

and Output per Employee to 24,279 for Quit Rate and Hire Rate. The mean value of Leverage

for firms in our sample is 0.229 and the median value is 0.191. The mean and median values of

Output per Employee are $237,605 and $162,317, respectively. Imputed Firm Value averages

$318,393 million with a median of $135.771 million. On a value-added basis, the summary

statistics for EBITDA per employee indicates that each employee produces an average (median)

of $22,673 ($15,168) of EBITDA per year.

The mean (median) values for the outside employment opportunity variables, Quit Rate

and Hire Rate, are 1.808% (1.500%) and 3.508% (2.942%), respectively. The mean and median

values for the third outside employment opportunity variable, Unemployment Growth Rate, are

1.222% and -3.488%, respectively. We do not winsorize industry-level variables but we find in

unreported tests that all results hold if we winsorize the three outside employment proxies at

their respective 1% and 99% values.

We present descriptive statistics for control variables in the bottom portion of Panel A.

The mean (median) asset intensity is $308,249 ($146,061) per employee. The number of

employees of firms in our sample varies widely. The minimum number of employees in a firm is

3 and the maximum number of employees in a firm is 116,192. To explore the possibility that

our results are driven by firms at either extreme, we conduct our analysis on a sample without

firms in the bottom (fewer than 62 employees) and top (more than 15,402 employees) deciles for
 13

the number of employees. Results for this subsample are similar to those for the entire sample,

which indicates that the results are not driven by very small or large numbers of employees. The

mean (median) firm age for our sample is 24 (21) year and the mean (median) operating leverage

is 0.547 (0.471). The mean Herfindhal Index is 0.072 and the median is 0.050.

In Panel B of Table 1, we report correlations between the leverage, productivity, and

outside employment opportunity variables. Consistent with the disciplining role of debt, there is

a significantly positive correlation between Leverage and all employment productivity measures.

The measures of outside employment opportunities, Quit Rate and Hire Rate are positively

correlated with each other. Since Unemployment Growth Rate measures a lack of outside

employment opportunities, it correlates negatively with Quit Rate and Hire Rate.

2.2.6 Employee Productivity by Industry

To examine the variation in employee productivity across industries, we compute median

values for the leverage, productivity, and outside employment opportunities variables in each 2-

digit SIC code defined industry. We present these statistics in Table 2. In the table, we rank

industries according to decreasing median values of Output per Employee and find that

productivity varies considerably across industries. The “Petroleum and Coal Products” industry

has the highest value and “Social Services” has the lowest value for Output per Employee. The

median Leverage is highest for “Automotive Repair, Services, and Parking” (0.43) and lowest

for “Business Services” (0.07). For outside employment opportunity measures, the highest

median values are in “Automotive Repair, Services, and Parking” for Quit Rate (4.93),

“Amusement and Recreational Services” for Hire Rate (7.29), and “Tobacco Manufacturers” for

Unemployment Growth Rate (4.60). The lowest medians are in “Educational Services” for Quit
 14

Rate (1.11), “Miscellaneous Repair Services” at 2.20 for Hire Rate, and “Furniture and Fixtures”

(-9.09) for Unemployment Growth Rate.

Given the considerable variation in employee productivity across industries, we use two

methods to control for industry effects. In the first method, we adjust firm-level continuous

variables, except Leverage, by subtracting the industry median based on the two-digit SIC codes

from the variable. Since our summary statistics indicate skewness in the data that varies by

industry, the median adjustment is likely a better measure of central tendency than the mean for

many industries. Further, we do not adjust Leverage by its industry median because, Ceteris

paribus, it is not clear if the likelihood of financial distress depends on the level of debt in the

firm or the industry-adjusted level. For completeness, however, we repeat our median-adjusted

regressions using industry median-adjusted leverage and find similar results to those reported in

the tables. In the second method, we include industry dummy variables in our specification to

control for industry fixed effects, which effectively adjusts all variables from the respective

industry mean.

3. Empirical model specification and estimation method

3.1. The empirical model specification

Our objective is to examine how the disciplining role of debt is affected by the changes in

outside employment opportunities. To establish a benchmark, we first establish the relation

between employee productivity and leverage without considering outside employment

opportunities and then modify the benchmark model to study the effects of outside employment

opportunities on the leverage-productivity relation. The regression specification for the

benchmark productivity-leverage relation is as follows:

 15

Output per Employeeit  0  1 Leverageit   k ControlVariables   it (1)

kK

The control variables include natural log value of Asset intensity, Employees, Firm Age,

Operating Leverage, Herfindahl Index, and year fixed effects. If the debt hypothesis holds in the

data the coefficient on Leverage, β1, should be positive.

We then examine if and how changes in outside employment opportunities affect the

relation between debt and employee productivity established in the benchmark specification. To

this end, we include interaction variables between different measures of outside employment

opportunities and Leverage. Specifically, we estimate the following augmented version of

equation (1):

Output per Employee  0  1 Leverageit   2 Leverageit * Outside Employment Opportunities

 3Outside Employment Opportunities    k ControlVariables   it (2)
kK

In the above specification, outside employment opportunities are the Quit Rate, the Hire

Rate, or the Unemployment Growth Rate. Our hypothesis states that if the outside employment

opportunities increase (decrease), then the relation between productivity and leverage will

become weaker (stronger). Therefore, we hypothesize that the coefficient 2 on the interaction of

Leverage and the outside employment measure will be negative for proxies where higher values

represent an increase in outside employment opportunities (e.g., quit rate and hire rate) and

positive for proxies where higher values represent a decrease in outside employment

opportunities (e.g., unemployment growth rate and NAFTA).

3.2 Endogeneity of leverage, productivity, and outside employment opportunities

Since unobserved variables, for instance, industry or managerial characteristics, may

affect the independent variable, Leverage, as well as the dependent variable, Output per
 16

Employee, it is possible that leverage and productivity are endogeneously determined. Outside

employment opportunities may also be endogenously determined. For example, productive

industries may generate more employment opportunities for employees in that industry or some

unobservable omitted variables, such as labor ability, may impact both employee productivity

and outside employment opportunities.

To address the possibility that the endogeneity between employee productivity and

outside employment opportunities may result in a spurious relation, we use the North American

Free Trade Agreement (NAFTA) as an exogenous shock to employment opportunities and show

how the passage of NAFTA changed the Leverage-Prodcutivity relation.

We control for the endogeneity of Leverage as follows. First, we remove industry effects

either by adjusting all firm-level variables, except Leverage, for the industry median in each year

or by using industry dummy variables.14 Second, we identify instrumental variables (IVs) for

Leverage and estimate 2- Stage Least Squares (2SLS) regressions in which predict Leverage in

the first stage and then we estimate the relation between predicted Leverage and employee

productivity in the second stage. In the industry-median adjusted regressions, we use the

variables Industry Median Leverage and Asset Beta as the two IVs. Industry Median Leverage is

the median value of Leverage for firms in the same two-digit SIC code. Research (e.g., Leary

and Roberts, 2005) shows that firms adjust their leverage to other firms in their industry and,

thus, Industry Median Leverage is a relevant instrumental variable for firm Leverage.15 The

second instrumental variable, Asset Beta, measures the systematic risk of the cash flows to the

firm’s assets and should relate negatively to the firm’s leverage. Since the Asset Beta measures

14
Campello (2006) argues that removing industry effects from variables mitigates the omitted variable problem
since it would be difficult to identify a variable that could “be correlated with the deviation of the included
variables’ realization from their mean for each industry in each year”.
15
Other researchers (e.g., Grullon, Kanatas, and Kumar, 2006) also use industry median leverage as an instrumental
variable for a firm’s leverage ratio.
 17

the systematic risk of the firm’s assets, we do not expect it to relate directly to employee

productivity. We obtain a firm’s Asset Beta as follows. First we estimate the firm’s equity beta

using a market model regression of daily returns on the CRSP value-weighted index, and then,

assuming that the debt has a beta of zero, we compute the asset beta as follows:16

EquityBeta
AssetBeta 
 Debt 
1  (1  Tax Rate)  
 Equity 

where the tax rate is computed as the firm’s total income taxes divided by the firm’s pre-tax

income in that year and the debt-to-equity ratio is the book value of long-term debt plus debt in

current liabilities divided by the market value of equity. For the sample of 105,704 firm years,

the mean (median) Asset Beta is 0.555 (0.639).

The first stage estimation for the base model in equation (1) is as follows:

Leverage = 0.206 + 0.476×Ind.Median Lev. – 0.102×Asset Beta + 0.019×Ln(Asset Int.)

(0.000) (0.000) (0.000)
+ 0.016×Ln(Employees) + 0.001×Ln(Firm Age) + 0.051×Ln(Operating Lev.)
(0.000) (0.748) (0.000)
– 0.031×Herfindahl Index + year dummies (Obs.=105,704; R2=25.26)
(0.100)

The coefficient on Industry Median Leverage is positive and statistically significant at the 1%

level, which is consistent with the premise that firms adjust their leverage to the industry norm.

The coefficient on Asset Beta is negative and statistically significant at the 1% level, indicating

that higher risk in the asset structure reduces the amount of debt the firm borrows. The Shea

partial R-square is 0.201 and the Hansen’s J-test has a p-value of 0.222, which suggest that our

IVs are relevant and valid.

We cannot use Industry Median Leverage as an IV in the regression with industry fixed

effects. Instead, we use the percentage of debt due in more than a year and the Asset Beta of the

16
We obtain similar results if we assume the debt beta to be 0.1, 0.2 or 0.3.
 18

firm as the two IVs for Leverage in the 2SLS with industry fixed effects. The first-stage Shea

partial R-square and p-values from the Hansen’s J-test (presented at the bottom of Table 4)

suggest that the IVs are relevant and valid.

In equation (2), we include an interaction term with outside employment opportunities

and Leverage. If Leverage is endogenous, then the interaction between the proxy for outside

employment opportunities and Leverage may also be endogenous. Following Woolridge (2002),

we estimate the predicted values of Leverage from the first stage using our previously defined

IVs, and then we use the product of the predicted Leverage and the proxy for outside

employment opportunities as the IV for the interaction term between Leverage and the proxy for

outside employment opportunities. Validity tests, presented at the bottom of each table, suggest

that our IVs are relevant and valid.

4. Effects of outside employment opportunities on the leverage-productivity relation

In this section, we present the results from estimating the benchmark Leverage-

Productivity relation (equation (1)), and how this relation is affected by outside employment

opportunities (equation (2)). We present results, from both OLS and 2SLS estimations, first for

industry median adjusted variables and then for industry fixed effects. We then present OLS and

2SLS results for the effect of the NAFTA shock on the Productivity-Leverage relation. At the

end of the section, we use the Imputed Firm Value as the dependent variable and present

evidence on the economic significance of all our findings.

4.1 Effects of cross-sectional measures of outside employment opportunities

We now present evidence on the benchmark Leverage-Productivity relation and on the

effect of changes in the three cross-sectional industry-level measures of outside employment

opportunities, the Quit Rate, Hire Rate, and Unemployment Growth Rate, on this relation. The
 19

findings from using industry median adjusted variables are in Table 3; the first four columns

present the OLS estimates and the last four the 2SLS estimates. The first (fifth) column presents

the OLS (2SLS) estimates of the benchmark specification. Columns 2 – 4 (6 – 8) present the

OLS (2SLS) findings on the effect of the three outside employment opportunity measures, Quit

Rate, Hire Rate, and Unemployment Growth Rate, respectively, on the Leverage-Productivity

relation. Note that higher values for Quit Rate and Hire Rate imply better and higher

Unemployment Growth Rate implies worse employment opportunities in the firm’s industry. The

p-values, presented in parentheses, are based on robust standard errors with firm clustering.

The coefficient on Leverage in column one is positive (0.151) and statistically significant

at the 1% level, which is consistent with the hypothesized disciplining role of debt. In column

two, the coefficient on the interaction term of Leverage and Quit Rate is significantly negative

(coefficient = -0.108, p-value = 0.011), which supports our hypothesis that the positive (or the

disciplining) effect of Leverage on productivity becomes less positive as the employment

opportunities improve. Using the Hire Rate as an alternative measure of outside opportunities

yields similar results, the coefficient on the interaction term in column three is negative (-0.083)

and significant at the 1% level. A higher value for the variable Unemployment Growth Rate

implies a worsening of the available job opportunities and as such should strengthen the

disciplining role of debt. The significantly positive coefficient (coefficient = 0.118, p-value =

0.000) in column four supports this hypothesize.

The findings presented in the last four columns from 2SLS estimations tell a similar

story. The coefficient on Leverage in column five of the table is significantly positive

(coefficient = 0.484, p-value = 0.000), which is consistent with the disciplining role of debt. The

coefficients on the interaction terms with Quit Rate and Hire Rate are significantly negative, and
 20

the interaction term with Unemployment Growth Rate is significantly positive, which is

consistent with the weakening of the debt-disciplining role as employment opportunities

improve.

The coefficients on Quit Rate and Hire Rate are positive in both OLS and 2SLS

specifications but are statistically significant only in the 2SLS estimation. The coefficient on

Unemployment Growth Rate is negative and statistically significant in both the OLS and 2SLS

estimations. The overall marginal impact of outside employment opportunities on the employee

productivity, however, includes the coefficient of the interaction term between Leverage and the

measures of outside employment opportunities. Setting Leverage to the mean value of 0.229, F-

tests indicate that the marginal impact of outside employment opportunities on employee

productivity is not statistically significantly different from zero in all the eight models in Table 3.

Table 4 presents the findings from the industry fixed effects approach. These findings are

similar to those reported for the industry median-adjusted approach. The significantly positive

coefficients on Leverage in columns one (for OLS) and five (for 2SLS) support the hypothesized

disciplining role of debt. The coefficients on the interaction terms between Leverage and Quit

Rate and Leverage and Hire Rate (columns 2 and 3) are both negative (p-values = 0.122 and

0.002, respectively) and significant, and the coefficient on the interaction term between Leverage

and Unemployment Growth Rate is positive with a p-value of 0.006. The 2SLS results in

columns 6 – 8 show that all the coefficients on the interaction terms have the same sign as the

corresponding ones in the OLS regressions and are statistically significant at the 1% level.

Thus, our hypothesis that an increase in outside employment opportunities weaken the

positive relation between leverage and employee productivity hold whether we use industry

median adjusted variables or industry fixed effects. Since the results from industry median
 21

adjusted and industry fixed effects approaches are qualitatively similar, we report only the

estimates based on the industry median-adjusted approach in the remainder of the paper.

4.2 The effect of an external shock to outside employment opportunities

The passage NAFTA in 1994 was an external shock to job opportunities in many

industries, and thus allows us to test our prediction that the efficacy of debt as a disciplinary

mechanism is affected by changes in outside employment opportunities available to employees,

particularly those in the manufacturing sector (Scott, 2003, 2001; Hottenrott and Blank, 1998).

Since NAFTA reduced employment opportunities, we predict that the disciplining role of debt is

stronger in the period after its passage in 1994. We analyze the whole sample as well as

subsamples of manufacturing (SIC codes 2000 – 3999) and non-manufacturing firms as

additional tests of our hypothesis.

We present the findings from our analysis of NAFTA as an exogenous shock to

employment opportunities in Table 5. The first two columns of Table 5 present the OLS and

2SLS estimations, respectively, for the whole sample. The coefficient on Leverage captures the

effect of Leverage on productivity when NAFTA is zero, that is, in the period prior to the passage

of the act in 1994. The coefficient on Leverage is significantly positive in both columns, which

indicates that the Leverage-Productivity relation was positive prior to NAFTA.17 The coefficients

on the interaction term in the two columns are positive; the 2SLS estimate is statistically

significant at the 1% level and the OLS estimate has a p-value of 0.11. These findings support

our hypothesis that the negative external shock in the form of NAFTA to employment

opportunities increased the efficacy of debt disciplining.

17
An F- test on the joint significance of Leverage and the interaction term with NAFTA indicates that total
Productivity-Leverage relation is significantly positive also after the passage of NAFTA.
 22

Columns three and four of Table 5 present the OLS and 2SLS estimates for the sub-

sample of manufacturing firms (SIC codes 2000 – 3999) and the last two columns for the sub-

sample of non-manufacturing firms. The coefficient on Leverage is positive and statistically

significant in all four cases, which implies that debt acted as a disciplinary mechanism prior to

1994 for firms in both manufacturing and non-manufacturing industries. The coefficient on the

interaction term Leverage*NAFTA is positive and significant only for firms in the manufacturing

firms. This finding offers strong support to our hypothesis that a worsening of job opportunities

increases the disciplining power of debt. The passage of NAFTA reduced employment prospects

primarily among manufacturing firms and the strengthening of the Leverage-Productivity

relation after NAFTA is also evident only among these firms.

4.3 Imputed firm value, financial leverage and outside employment opportunities

We next use Imputed Firm Value, based on the median value-to-productivity multiplier

for the industry, instead of Output per Employee as the dependent variable in the regression.

Table 6 presents results from the OLS and 2SLS estimations of the relation between Leverage

and Imputed Firm Value. The results are similar to those when Output per Employee is the

dependent variable. The coefficient on Leverage is positive and statistically significant at the 1%

level for all three models in both OLS and 2SLS estimations, the coefficients on the interaction

terms with Quit Rate and Hire Rate are both negative and statistically significant, and the

coefficient on the interaction term with Unemployment Growth Rate is significantly positive.

To assess the economic significance and magnitude of these effects, we compute the

change in productivity when leverage increases from the 25th percentile to the 75th percentile at

two values of outside employment opportunities, the 25th and the 75th percentiles. According to

our hypothesis and the results presented earlier, the change in productivity from an increase in
 23

Leverage should be lower when the outside employment opportunities are better (75th

percentile). We estimate economic significance for the employment opportunity measures Quit

Rate and Hire Rate (whose higher values represent better employment opportunities) and present

the results in Panel A of Table 7. As benchmarks for comparison, Panel B presents the findings

from a similar analysis for selected control variables. In each panel, the first column presents the

change in Output per Employee, the second column presents the change in Imputed Firm Value

($ millions), and the third column reports the % changes in Imputed Firm Value. In the

computations, we hold all the other independent variables constant at their mean values.

In Panel A of Table 7, when the Quit Rate is at the 25th percentile value, increasing

Leverage from the 25th to the 75th percentile increases Output per Employee by 8.52% (11.44%)

in the OLS (2SLS) specification; the analogous values for Hire Rate are 9.46% and 11.56%.

When the value of Quit Rate or Hire Rate is at the 75th percentile (implying better employment

opportunities), the corresponding increase in Output per Employee for a change in leverage from

the 25th to the 75th percentiles is lower by about half. Specifically, employee productivity

increases by 4.54% (6.97%) and 3.85% (6.45%), respectively for the Quit Rate and Hire Rate, in

the OLS (2SLS) specifications. For Imputed Firm Value, when the employment opportunity

measures are at the 25th percentile value, the change in firm value is in excess of $12 million

($16 million); when the employment opportunities are at the 75th percentile, increasing Leverage

improves firm value by less than $7 million ($10.3 million) in OLS (2SLS) specifications. The

magnitudes of the % change in Imputed Firm Value are similar to those for Output per

Employee. Comparing these magnitudes to those in Panel B of Table 7 shows that only Asset

Intensity has a bigger impact on employee productivity; changes in the number of employees,

Firm Age, and Operating Leverage have lower impacts on employee productivity.
 24

We also compute the respective economic significance of the productivity-leverage

relation when outside employment opportunities are set to the 10th, 25th, 50th, 75th, and 90th

percentiles, respectively. Figure 1.A presents the plot of these five economic significance values

for Quit Rate and Figure 1.B presents the graphs for Hire Rate. Both figures highlight the fact

that the impact of Leverage on productivity and firm value is monotonically decreasing when

outside employment opportunities increase. Furthermore, the reduction in the impact of Leverage

on productivity appears to be economically significant. For example, an increase in the Quit

Rate from the 10th percentile to the 90th percentile, based on the estimates from OLS regressions,

reduces the effect of Leverage on Output per Employee (Imputed Firm Value) from about 10%

($13m) to less than 3% ($4m), a reduction of 70% (69%).

In summary, our analysis suggests that the positive impact of Leverage on employee

productivity and firm value is economically significant, and that the impact of Leverage is

significantly reduced if employees have better outside employment opportunities.

5. Robustness Checks

To verify the robustness of our results, we conduct several additional tests: (i) analysis at

the industry level (ii) allowing for a non-linear relation by including a quadratic Leverage term in

the regression of productivity on Leverage, (iii) analyzing a smaller sample that allows inclusion

of five additional control variables in the regression, (iv) using EBITDA per Employee as an

alternative measure of employee productivity, (v) using a sample that includes firms with no

debt, (vi) using a sample that excludes firms in the top Leverage quartile, (vii) using a sample

with an alternative control for M&A events, and (viii) using a sample that excludes very large or

small firms. The findings from estimating the benchmark models in equation (1) are similar to
 25

those reported in the main tests and we do not present them for space considerations. We present

only the 2SLS estimates and note that the results are unchanged if we use OLS.

5.1 Industry-level Regressions

As an alternative control for endogeneity that might arise at the firm level, we estimate

our tests at the industry level using the industry median values based on two-digit SIC codes for

each variable. The results from this analysis presented in Table 8 indicate that all the previous

findings continue to hold at the industry level. The positive Leverage-Productivity relation is

weaker (stronger) when employees have more (fewer) outside opportunities; coefficients on the

interaction terms are all statistically significant with p-values ranging from 0.01 to 0.069.

5.2 Alternative model specifications

5.2.1 Quadratic-form regression

In prior sections, we present the results of tests that exclude firms in the top leverage

decile to eliminate financially distressed firms. We now include firms in the top leverage decile

and fit a non-linear relation between employee productivity and leverage by including Leverage2

as an additional independent variable. We hypothesize a (positive) concave relation; a positive

relation at lower debt levels and a negative one at sufficiently high levels of debt. The intuition is

that at high debt levels, the effects of financial distress will be large enough to cause lower

marginal productivity gains as debt increases. We do not report the results from the benchmark

specification but note that the coefficient on Leverage is significantly positive and that on

Leverage2 is significantly negative. This positive concave relation is consistent with our

expectation that the disciplinary benefit of debt is offset by expected financial distress costs at

sufficiently high debt levels.

 26

To explore the impact of outside employment opportunities on a concave Leverage-

Productivity relation, we augment equation 2 by including an interaction term between proxies

for outside employment opportunities and Leverage2 in addition to the interaction term for

Leverage. We present the results from these tests in the first three columns of Table 9. For both

Quit Rate and Hire Rate, the coefficient on the interaction term between Leverage and the

outside employment measure is significantly negative, and the coefficient on the interaction term

with Leverage2 is significantly positive. For Unemployment Growth Rate, the respective

coefficients have the expected opposite signs. These findings indicate that increases (decreases)

in outside employment opportunities dampen (strengthen) the concave productivity-leverage

relation. Our main findings that more outside employment opportunities of employees weaken

the disciplining role of debt remains robust in this alternative specification when the leverage

ratio is lower than the inflection point (around 0.48).

5.2.2 Additional Control Variables

Next, we control for factors such as unionization, wage levels, external monitoring

mechanisms, the work environment and non-pecuniary compensation, and employee pension

plans that are also likely to influence productivity. We measure the degree of external monitoring

by the percentage of block holdings (5% or more of outstanding shares) of institutional investors

obtained from the CDA Spectrum database of SEC 13-f filings which is available for years 1980

to 2007. We proxy for the expected wage by the average weekly earnings in the firm’s industry

computed using the Current Employment Statistics (CES) survey from BLS. Pension plans,

particularly defined benefit pension plans, provide employees with incentives to work harder and

improve productivity (Ippolito, 1998) and, therefore, we include a dummy variable that equals
 27

one if the firm has a defined benefit plan. The information on defined benefit plans is available in

Compustat (data item 287 or 296) from 1986 to 2007.

To control for the effects of unionization on employee productivity, we include the

variable Union Membership, the fraction of workers in an industry who belong to a union, as a

control variable in our analysis.18 The Current Population Survey (CPS) union membership

database compiled by Hirsch and Macpherson (http://www.unionstats.com/) provides

information on union membership from 1983-2007 based on CIC (Census/CPS Industry Codes)

classifications. We use the matching table provided by Hirsch and Macpherson to match union

coverage at the 4- or 3-digit SIC code level.19 As a measure of good work environment and non-

pecuniary compensation, we include a dummy variable, Best Company, which equals one if the

firm is in Fortune Magazine’s list of “100 best companies to work for” (available from 1998 to

2007). The summary statistics for these control variables are presented at the bottom of Panel A

in Table 1, and the last three columns of Table 9 present regression results that include all these

additional control variables. Consistent with our previous findings, the coefficients on the

interaction terms between Leverage and all three outside employment opportunities measures

have the expected sign and are statistically significant at the 1% level.

5.3 An alternative measure of employee productivity

The employee productivity measure in earlier tests, Output per employee, is based on the

total output (sales plus changes in inventories) of the firm. As an alternative measure that

captures the value added by employees, we use EBITDA per Employee, which is the ratio of

operating income before depreciation and amortization (data item 13) to the number of

18
Baldwin (1983) argues that firms keep inefficient plants to discourage unions from bargaining for higher wages.
Doucouliagos and Laroche (2003) find a positive relation between unionization and productivity for U.S. firms.
Chen, Kacperczyk, and Ortiz-Molina (2009a,b) argue that unions reduce the agency costs of financing.
19
See Hirsch and Macpherson (2003) for a detailed description on this union membership database.
 28

employees. We present results from the 2SLS estimations in Table 10 for the three outside

employment opportunities measures. The results for the value-added measure are similar to those

for Output per Employee. The coefficient on the interaction term between Leverage and outside

employment opportunities is negative and statistically significant at the 5% level for the Quit

Rate and Hire Rate, and positive and statistically significant at the 10% level for the

Unemployment Growth Rate.

5.4 Alternative samples

5.4.1 Including zero-debt firms

The analysis thus far includes only firms with positive debt levels because research

indicates that zero-debt firms are systematically different from firms with debt. We relax this

restriction and include zero-debt firms in the sample, and present our findings in the first three

columns of Table 11. Consistent with the previous findings, the coefficients on the interaction

terms are negative and statistically significant for both Quit Rate and Hire Rate, and positive and

statistically significant for the Unemployment Growth Rate.

5.4.2 Excluding firms in the top quartile

In our main tests, we exclude firms in the top decile for Leverage. To ensure that our

results are not sensitive to the decile cutoff, we repeat our analysis by excluding firms in the top

quartile and present results for this alternative sample in the last three columns of Table 11.

Again, we find that the coefficients on the interaction terms are negative and statistically

significant for Quit Rate and Hire Rate; and that on the interaction term for Unemployment

Growth Rate is significantly positive.

 29

5.4.3 Excluding firms with the most and the fewest number of employees

The number of employees for firms in our sample ranges from three employees to

116,192 employees. We repeat all our analysis for a subsample that excludes firms with the

number of employees in the bottom (less than 62 employees) and top (more than 15,402

employees) deciles and present the results in the first three columns of Table 12. The coefficients

on the interaction terms are similar to results reported in earlier sections, which suggests that our

results are not driven by very small or large firms.

5.4.4 An alternative control for M&A events

In the analysis thus far, we control for the impact of M&A activities by omitting firms

with sales growth greater than 200%. Firms report the impact of M&A on their sales in their

income statements (Compustat data item 249). We repeat all our reported tests on the subsample

that excludes firm-years in which firms reported M&A sales impact and present the results in the

last three columns of Table 12. The coefficient on the interaction term is negative and

statistically significant at the 1% level for the Quit Rate and Hire Rate; and that for the

Unemployment Growth Rate is positive and statistically significant at the 5% level.

In sum, the effects of outside employment opportunities on the productivity-leverage

relation are robust to alternative model specifications, different sample classifications for

Leverage, M&A events, and firm size. The results are also similar when we conduct our analysis

on the industry level.

6. Concluding Remarks

We propose that better outside employment opportunities weaken the efficacy of debt as

a disciplining mechanism and worse outside employment opportunities strengthen the efficacy.
 30

As a direct test of the debt disciplining hypothesis, we analyze the relation between employee

productivity and financial leverage and examine its interaction with changes in labor market

conditions in a large sample of publicly held firms over a span of 31 years. Supporting the

premise that debt serves as a costly disciplining mechanism to mitigate agency conflicts; we find

that financial leverage exerts a positive influence on employee productivity. Consistent with our

hypothesis, we find that the influence of financial leverage on employee productivity is weaker

when employees have more outside employment opportunities and stronger when outside

employment opportunities are worse.

The results from our tests imply that employees compare the costs that they incur to

lessen the likelihood of financial distress, for instance additional effort, to the transaction costs of

leaving the firm. As outside employment opportunities increase, the relative costs of leaving the

firm become less than the costs of additional effort, and debt becomes less effective as a

disciplining device. Thus, our results for the influence of outside employment opportunities on

the relation between productivity and financial leverage emphasize the fact that disciplining costs

are borne by the agent. Collectively, the positive relation between employee productivity and

financial leverage strongly support the debt disciplining arguments of Grossman and Hart (1982)

and Jensen (1986).

More broadly, our study suggests that researchers studying control and alignment

mechanisms and policymakers and activists who seek to improve governance in publicly held

firms should consider the interaction of the labor markets with a firm’s attempts to mitigate

agency problems. Governance and other control mechanisms minimize agency conflicts because

they impose costs on agents for behavior that is inconsistent with shareholder wealth

maximization and reward behavior that is aligned with the objective of maximizing shareholder
 31

wealth. Our results for the influence of outside employment opportunities on the efficacy of debt

as a disciplining mechanism highlight the importance of controlling for labor market conditions

in studies that examine the usefulness of other governance and incentive alignment mechanisms.

Our results also suggest that the constrained optimal equilibrium level of any governance

mechanism will vary across industries and over time with conditions in the labor markets. Hence,

our findings highlight the influence of both financial and nonfinancial markets on the efficacy of

these observed equilibrium outcomes.

 32

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 FIGURE 1
The Impact of Outside Employment Opportunities on the Productivity-leverage Relation
Figure 1. A; Quit Rate and changes in employee productivity when Leverage changes from 25th to 75th percentile.
This figure presents changes in Output per Employee and Imputed Firm Values when Leverage changes from 25th to
75th percentile holding quit rate at different levels. We present changes in employee productivity based on
estimations from both OLS and 2SLS. Quit Rate is the number of employees in an industry that voluntarily quit their
jobs divided by the total number of employees in the industry. We measure Output per Employee as sales plus
changes in inventories divided by the number of employees. Imputed Firm Value equals Output per Employee
multiplied by the industry median of firm value per unit of employee productivity.

(% or $m)

Quit Rate
(continued on next page)
 FIGURE 1 (continued)
The Impact of Outside Employment Opportunities on the Productivity-leverage Relation

Figure 1. B: Hire rate and changes in employee productivity when Leverage changes from 25th to 75th percentile.
This figure presents changes in Output per Employee and Imputed Firm Values when Leverage changes from 25th to
75th percentile holding hire rate at different levels. We present changes in employee productivity based on
estimations from both OLS and 2SLS. Hire rate is the total number of new hires in an industry divided by the total
number of employees. We measure Output per Employee as sales plus changes in inventories divided by the number
of employees. Imputed Firm Value equals Output per Employee multiplied by the industry median of firm value per
unit of employee productivity.

(% or $m)

Hire Rate
 TABLE 1
Descriptive Statistics
The sample is from the Compustat database for 1976-2007 and excludes firms with no debt or debt ratios above the
90th percentile (0.658). Leverage is the book value of debt divided by the book value of debt plus market value of
common equity. Output per Employee is sales plus changes in inventories divided by the number of employees.
Firm Value Multiplier is the industry median firm value (market value of equity plus book value of debt) per unit of
employee productivity. Imputed Firm Value equals Output per Employee times the Firm Value Multiplier. EBITDA
per Employee is the ratio of operating income before depreciation and amortization to the number of employees.
Quit Rate is the number of employees in an industry that voluntarily quit their jobs divided by the total number of
employees in the industry. Hire rate is the total number of new hires in an industry divided by the total number of
employees. Quit Rate and Hire Rate are available for 2000-2007. Unemployment Growth Rate is the growth rate of
the industry unemployment rate. Union Membership is the fraction of workers in an industry who belong to a union
and is available for 1983-2007. Defined Benefits Plan equals one if the firm has defined benefit pension plans and is
available for 1986 - 2007. Best Company dummy equals one if the firm year is in the list of “100 best companies to
work for in America” by Fortune magazine during 1998 - 2007. Industry Weekly Earnings is the weekly earnings
per employee in an industry. Institutional Block Ownership is the percentage of 5% institutional block holdings and
is available for 1980-2007. Employees is the number of employees reported in Compustat. Asset Intensity is total
assets divided by the number of employees. Firm Age is the number of years the firm appears in Compustat.
Operating Leverage is gross Property, Plant & Equipment divided by total assets. The Herfindahl Index for a 2-
digit SIC code industry is the sum of the squared market share of each firm in that industry. We winsorize all firm-
level variables at the 1% and 99% values.
Panel A. Summary Statistics
Variables Obs. Mean Median Maximum Minimum Std. Dev.
Leverage 105,704 0.229 0.191 0.658 0.000 0.186
Employee Productivity
Output per Employee ($k) 105,704 237.605 162.317 1759.976 7.261 269.845
Firm Value Multiplier (000s) 105,704 1.217 0.758 8.968 0.123 1.388
Imputed Firm Value ($m) 105,704 318.393 135.771 4526.592 5.397 594.099
EBITDA per Employee ($k) 105,704 22.673 15.168 452.767 -289.329 86.736
Outside Employment Opportunity
Quit Rate (%) 24,279 1.808 1.500 5.267 0.400 0.745
Hire Rate (%) 24,279 3.508 2.942 7.967 1.300 1.386
Unemployment Growth Rate (%) 96,818 1.222 -3.488 120.833 -55.000 28.918
Control Variables
Employees (k) 105,704 6.609 0.925 116.192 0.003 17.053
Asset Intensity ($k) 105,704 308.249 146.061 3658.808 14.934 545.716
Firm Age 105,704 23.587 21 57 4 11.805
Operating Leverage 105,704 0.547 0.471 2.039 0.020 0.371
Herfindahl Index 105,704 0.072 0.050 0.916 0.014 0.073
Union Membership (%) 86,578 11.953 8.100 83.600 0.000 12.033
Best Co. (0/1) (%) 32,456 0.949
Defined Benefits Plan (0/1) (%) 76,725 27.823
Industry Weekly Earnings ($) 104,644 494.654 465.650 1453.190 76.670 227.170
Institutional block ownership (%) 95,615 8.867 4.666 52.784 0.000 12.143
(continued on next page)
 TABLE 1 (continued)
Descriptive Statistics

Panel B. Pearson Correlations among Leverage, Employee Productivity and Outside Employment Opportunities
Output per Imputed Firm EBITDA per
Leverage Employee($k) Value ($m) Employee($k) Quit Rate Hire Rate
Leverage 1

Output per Employee($k) 0.039*** 1

Imputed Firm Value ($m) 0.055*** 0. 536*** 1

EBITDA per Employee($k) 0.062*** 0.559*** 0.326 *** 1

Quit Rate -0.020** -0.096*** -0.017*** -0.034*** 1

Hire Rate -0.022*** -0.043*** -0.039*** 0.015** 0.912*** 1

Unemployment Growth Rate 0.017*** -0.011*** -0.013** -0.037*** -0.079*** -0.081***

 TABLE 2
Median Employee Productivity, Leverage, and Outside Employment Opportunities by Industry
This table presents the median employee productivity by industry. The sample of firms is from the Compustat
database for 1976-2007 and excludes firms with no debt or debt ratios above the 90th percentile (0.658). Output per
Employee is the ratio of sales plus changes in inventories to the number of employees. Imputed Firm Value equals
Output per Employee multiplied by the industry median of firm value per unit of employee productivity. We define
firm value as market value of equity plus book value of debt. Quit Rate is the number of employees in an industry
that voluntarily quit their jobs divided by the total number of employees in the industry. Hire rate is the total number
of new hires in an industry divided by the total number of employees. Quit Rate and Hire Rate are available for
2000-2007. Unemployment Growth Rate is the growth rate of the unemployment rate by industry. The industry
descriptions for two-digit SIC codes are from U.S. Census Bureau. We present industries in descending order of
Output per Employee.
Output per Quit Hire Unemployment
Employee Rate Rate Growth Rate
SIC Industry Description ($k) Leverage (%) (%) (%)
29 Petroleum and coal products 822.41 0.29 1.58 2.81 -7.32
15 General building contractors 543.47 0.41 2.33 6.47 -7.88
51 Wholesale trade--nondurable goods 402.42 0.28 1.50 2.83 -3.85
50 Wholesale trade--durable goods 345.90 0.28 1.48 2.83 -3.85
13 Oil and gas extraction 334.25 0.21 1.60 3.81 -3.23
12 Coal mining 324.67 0.36 1.73 3.83 3.23
21 Tobacco manufactures 244.05 0.24 1.58 2.81 4.60
14 Nonmetallic minerals, except fuels 243.27 0.20 1.73 3.83 -3.23
44 Water transportation 233.36 0.36 1.52 3.08 -4.44
33 Primary metal industries 230.43 0.32 1.30 2.53 -8.89
47 Transportation services 226.37 0.12 1.52 3.08 -6.06
20 Food and kindred products 225.82 0.24 1.58 2.81 -1.37
26 Paper and allied products 212.65 0.31 1.58 2.81 -8.89
52 Building materials, hardware, garden supply & mobile 204.46 0.26 3.10 4.80 -3.51
48 Communications 203.30 0.26 1.48 3.08 -6.98
28 Chemicals and allied products 198.06 0.10 1.58 2.81 -2.50
10 Metal mining 187.35 0.12 1.73 3.83 -4.55
57 Furniture, home furnishings and equipment stores 184.56 0.24 3.10 5.04 -3.17
54 Food stores 183.06 0.35 3.10 5.04 -3.03
78 Motion pictures 175.62 0.23 2.64 7.16 -3.70
32 Stone, clay, glass, and concrete products 175.13 0.31 1.20 2.40 -3.33
16 Heavy construction contractors 174.18 0.19 2.33 6.32 -7.88
55 Automotive dealers and gasoline service stations 171.14 0.31 2.98 5.04 -3.51
45 Transportation by air 168.60 0.36 1.52 3.08 -6.06
35 Industrial machinery and equipment 168.36 0.16 1.20 2.40 0.00
24 Lumber and wood products 167.81 0.28 1.58 2.81 -8.06
30 Rubber and miscellaneous plastics products 164.29 0.24 1.20 2.40 1.33
27 Printing and publishing 161.48 0.17 1.58 2.80 -4.65
59 Miscellaneous retail 158.54 0.18 3.10 4.88 -3.51
(continued on next page)
 TABLE 2 (continued)
Median Employee Productivity, Outside Employment Opportunities and Leverage by Industry
Output per Quit Hire Industry
Employee Leverage Rate Rate Unemployment
SIC Industry Description ($k) (%) (%) Growth %
37 Transportation equipment 158.12 0.24 1.30 2.53 -3.70
34 Fabricated metal products 152.36 0.27 1.20 2.40 -5.56
17 Special trade contractors 151.55 0.18 2.29 6.32 -5.68
39 Miscellaneous manufacturing industries 150.28 0.22 1.20 2.40 -7.87
73 Business services 146.28 0.07 2.70 5.61 -2.08
38 Instruments and related products 145.68 0.11 1.20 2.40 -3.85
36 Electrical and electronic equipment 141.66 0.14 1.20 2.40 -3.45
31 Leather and leather products 126.04 0.21 1.20 2.40 -5.15
23 Apparel and other textile products 125.19 0.23 1.58 2.81 -4.44
25 Furniture and fixtures 124.64 0.23 1.58 2.81 -9.09
42 Motor freight transportation and warehousing 124.03 0.30 1.48 3.08 -6.06
22 Textile mill products 122.34 0.37 1.70 2.80 -7.02
53 General merchandise stores 120.75 0.32 3.04 5.04 -3.17
75 Automotive repair, services, and parking 110.40 0.43 4.93 6.94 -2.20
76 Miscellaneous repair services 109.92 0.20 1.70 2.20 -1.75
87 Engineering and management services 107.49 0.10 2.70 5.61 0.00
56 Apparel and accessory stores 103.46 0.13 3.04 4.88 -3.51
82 Educational services 97.32 0.09 1.11 2.46 -1.82
80 Health services 89.50 0.21 1.88 3.06 0.00
79 Amusement and recreational services 80.61 0.31 2.65 7.29 -3.70
72 Personal services 68.42 0.21 2.73 5.65 -2.08
70 Hotels, rooming houses, camps, and other lodging 56.99 0.38 4.80 6.94 -3.70
58 Eating and drinking places 39.59 0.22 3.10 4.88 -3.37
83 Social services 27.98 0.33 1.83 3.01 0.00
 TABLE 3
Outside Employment Opportunities, Employee Productivity, and Leverage: Industry Median Adjusted Analysis
This table presents OLS and 2SLS regression results of the employee productivity-leverage relation and the effect of outside employment opportunities on the
productivity-leverage relation. Except for Leverage, we adjust all continuous firm-level variables for their respective industry medians in each year to control for
industry effects. The sample is from the Compustat database for 1976-2007 and excludes firms with no debt or debt ratios above the 90th percentile (0.658). The
dependent variable is the natural log of Output per Employee. In 2SLS estimations, instrumental variables for Leverage are the median leverage of the firm’s
industry and the firm’s asset beta. Table 1 presents definitions for all variables. We present p-values, adjusted for heteroskedasticity and firm clustering, in
parentheses. *** significant at 1% level; ** significant at 5% level; * significant at 10% level.
Outside Employment Opportunities (OLS) Outside Employment Opportunities (2SLS)
Unemployment Unemployment
Base (OLS) Quit Rate Hire Rate Growth Rate Base (2SLS) Quit Rate Hire Rate Growth Rate
Leverage 0.151*** 0.408*** 0.506*** 0.065*** 0.484*** 1.285*** 1.379*** 0.301***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Leverage * Outside Emp. Opportunities -0.108** -0.083*** 0.118*** -0.299*** -0.187*** 0.265***
(0.011) (0.000) (0.000) (0.000) (0.000) (0.000)
Outside Employment Opportunities 0.007 0.008 -0.052*** 0.052** 0.032*** -0.085***
(0.605) (0.341) (0.000) (0.013) (0.007) (0.000)
Ln(Employees) 0.035*** 0.027*** 0.027*** 0.024*** 0.033*** 0.024*** 0.025*** 0.023***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Ln(Asset Intensity) 0.529*** 0.522*** 0.522*** 0.543*** 0.528*** 0.521*** 0.528*** 0.543***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Ln(Firm Age) 0.053*** 0.091*** 0.091*** 0.053*** 0.056*** 0.089*** 0.092*** 0.054***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Operating Leverage 0.096*** 0.211*** 0.212*** 0.063*** 0.078*** 0.185*** 0.185*** 0.052***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.001)
Herfindahl Index 0.154*** 0.485*** 0.490*** 0.127** 0.060 0.233* 0.227* 0.060
(0.006) (0.000) (0.000) (0.024) (0.292) (0.096) (0.091) (0.285)
Intercept -0.187*** -0.120*** -0.134*** -0.145*** -0.283*** -0.281*** -0.368*** -0.062***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Year Dummies Yes Yes Yes Yes Yes Yes Yes Yes
Industry-median-adjusted Firm-level
Yes Yes Yes Yes Yes Yes Yes Yes
Variables
Observations 105,704 24,279 24,279 96,818 105,704 24,279 26,491 96,818
R2 0.300 0.293 0.293 0.338 0.292 0.278 0.284 0.334
Hansen’s J-test (p-value): 0.222 0.176 0.245 0.683
First-stage Shea partial R-square for Leverage: 0.201 0.257 0.251 0.201
First-stage Shea partial R-square for the interaction term: 0.285 0.282 0.233
 TABLE 4
Outside Employment Opportunities, Employee Productivity and Leverage: Analysis Based on Industry Fixed Effects
This table presents the OLS and IV/2SLS regression results of employee productivity-leverage relation and the effect of outside employment opportunities on the
productivity-leverage relation. The sample is from the Compustat database for 1976-2007 and excludes firms with no debt or debt ratios above the 90th percentile
(0.658). The dependent variable is the natural log of Output per Employee. In 2SLS estimation, the instrumental variables for Leverage are the percentage of debt
due in more than one year and the asset beta of the firm. Table 1 presents definitions for all variables. We present p-values, adjusted for heteroskedasticity and
firm clustering, in parentheses. *** significant at 1% level; ** significant at 5% level; * significant at 10% level.
Outside Employment Opportunities (OLS) Outside Employment Opportunities (2SLS)
Unemployment Unemployment
Base(OLS) Quit Rate Hire Rate Growth Rate Base(2SLS) Quit Rate Hire Rate Growth Rate
Leverage 0.089*** 0.270*** 0.432*** 0.038** 0.470*** 1.251*** 1.587*** 0.367***
(0.000) (0.004) (0.000) (0.039) (0.000) (0.000) (0.000) (0.000)
Leverage * Outside Emp. Opportunities -0.072 -0.084*** 0.090*** -0.223** -0.218*** 0.196***
(0.122) (0.002) (0.006) (0.040) (0.000) (0.008)
Outside Employment Opportunities 0.075*** 0.103*** -0.064*** 0.120*** 0.135*** -0.085***
(0.002) (0.000) (0.000) (0.001) (0.000) (0.000)
Ln(Employees) 0.040*** 0.031*** 0.031*** 0.029*** 0.037*** 0.024*** 0.024*** 0.026***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Ln(Asset Intensity) 0.531*** 0.532*** 0.533*** 0.543*** 0.530*** 0.526*** 0.527*** 0.544***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Ln(Firm Age) 0.076*** 0.090*** 0.090*** 0.065*** 0.071*** 0.094*** 0.093*** 0.059***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Operating Leverage 0.106*** 0.228*** 0.229*** 0.071*** 0.080*** 0.174*** 0.178*** 0.047***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.003)
Herfindahl Index -0.050* 0.107** 0.109** -0.029 -0.538*** -0.252 -0.157 -0.499***
(0.052) (0.030) (0.028) (0.243) (0.000) (0.236) (0.458) (0.000)
Intercept 2.179*** 1.890*** 1.532*** 2.328*** 1.770*** 1.514*** 1.322*** 1.820***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Year Dummies Yes Yes Yes Yes Yes Yes Yes Yes
Industry Dummies Yes Yes Yes Yes Yes Yes Yes Yes
Observations 105,704 24,279 24,279 96,818 105,704 24,279 24,279 96,818
R2 0.498 0.497 0.498 0.534 0.492 0.482 0.483 0.535
Hansen’s J-test (p-value): 0.559 0.637 0.685 0.756
First-stage Shea partial R-square for Leverage: 0.107 0.163 0.169 0.113
First-stage Shea partial R-square for the interaction term: 0.179 0.180 0.246
 TABLE 5
NAFTA, Employee Productivity, and Leverage
This table presents the OLS and 2SLS results of the effect of NAFTA on the productivity-leverage relation. The
sample is from the Compustat database for 1976-2007 and excludes firms with no debt or debt ratios above the 90th
percentile (0.658). Except for Leverage, we adjust all continuous firm-level variables for the respective industry
median in each year. The dependent variable is the natural log of Output per Employee, which we define as sales
plus changes in inventories divided by the number of employees. Leverage is the ratio of book value of debt divided
by the sum of book value of debt plus market value of common equity. In the 2SLS estimation, the instrumental
variables for Leverage are the median leverage of the firm’s industry and the firm’s asset beta. NAFTA equals one
for observations in year 1994 and onwards, and equals zero otherwise. Leverage*NAFTA is the product of Leverage
and the NAFTA dummy. Manufacturing firms include all firms with SIC codes between 2000 and 3999. Non-
manufacturing firms include all firms with SIC codes smaller than 2000, and larger than 3999. Table 1 presents
definitions for all other variables. We present p-values, adjusted for heteroskedasticity and firm clustering, in
parentheses. *** significant at 1% level; ** significant at 5% level; * significant at 10% level.
Non-Mfg
All Firms All Firms Mfg. Firms Mfg. Firms Non-Mfg Firms
(OLS) (2-SLS) (OLS) (2-SLS) Firms (OLS) (2-SLS)
Leverage 0.127*** 0.297*** 0.162*** 0.437*** 0.081** 0.159**
(0.000) (0.000) (0.000) (0.000) (0.018) (0.034)
Leverage * NAFTA 0.051 0.268*** 0.128*** 0.403*** -0.037 0.133
(0.110) (0.000) (0.004) (0.000) (0.440) (0.182)
NAFTA 0.005 -0.030 -0.013 -0.050* 0.029* -0.004
(0.637) (0.116) (0.390) (0.065) (0.086) (0.891)
Ln(Employees) 0.038*** 0.036*** 0.046*** 0.043*** 0.031*** 0.029***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Ln(Asset Intensity) 0.530*** 0.530*** 0.492*** 0.498*** 0.553*** 0.551***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Ln(Firm Age) 0.037*** 0.037*** 0.047*** 0.046*** 0.023** 0.025**
(0.000) (0.000) (0.000) (0.000) (0.019) (0.013)
Operating Leverage 0.101*** 0.087*** 0.046** 0.028 0.127*** 0.119***
(0.000) (0.000) (0.037) (0.217) (0.000) (0.000)
Herfindahl Index 0.156*** 0.081 0.470*** 0.280* 0.137** 0.101
(0.005) (0.152) (0.003) (0.070) (0.027) (0.106)
Intercept -0.180*** -0.216*** -0.213*** -0.267*** -0.154*** -0.172***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Industry-median-adjusted
Yes Yes Yes Yes Yes Yes
Firm-level variables
Observations 105,704 105,704 59,416 59,416 46,288 46,288
2
R 0.298 0.292 0.242 0.230 0.355 0.353

Hansen's J-test (p-value): 0.225 0.897 0.170

First-stage Shea partial R2 for Leverage: 0.214 0.200 0.232
First-stage Shea partial R2 for the
interaction term: 0.236 0.216 0.253
 TABLE 6
Imputed Firm Value, Financial Leverage and Outside Employment Opportunities
This table presents OLS and 2SLS results on the relation between the imputed firm value and financial leverage.
The sample is from the Compustat database for 1976-2007 and excludes firms with no debt or debt ratios above the
90th percentile (0.658). Except for Leverage, we adjust all continuous firm-level variables for their respective
industry medians in each year to control for industry effects. The first three columns present the results from OLS
estimations and the last three columns present the results from the IV/2SLS estimations. The dependent variable is
the natural log of Imputed Firm Value, which equals Output per Employee multiplied by the industry median of firm
value per unit of employee productivity. Firm value is defined as market value of equity plus book value of debt.
Leverage and the product of Leverage*Outside Employment Opportunities are the predicted values from the first
stage. In 2SLS estimation, the instrumental variables for Leverage are the median leverage of the firm’s industry
and the firm’s asset beta. Table 1 presents definitions for all other variables. We present p-values, adjusted for
heteroskedasticity and firm clustering, in parentheses. *** significant at 1% level; ** significant at 5% level; *
significant at 10% level.
OLS 2SLS
Unemployment Unemployment
Quit Rate Hire Rate Growth Rate Quit Rate Hire Rate Growth Rate
Leverage 0.432*** 0.530*** 0.075*** 1.396*** 1.551*** 0.346***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Leverage * Outside Employment -0.112*** -0.086*** 0.124*** -0.320*** -0.208*** 0.273***
Opportunities (0.009) (0.000) (0.000) (0.000) (0.000) (0.000)
Outside Employment 0.004 0.007 -0.054*** 0.053** 0.034*** -0.088***
Opportunities (0.777) (0.411) (0.000) (0.014) (0.005) (0.000)
Ln(Employees) 0.027*** 0.027*** 0.025*** 0.023*** 0.024*** 0.023***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Ln(Asset Intensity) 0.532*** 0.532*** 0.552*** 0.531*** 0.532*** 0.552***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Ln(Firm Age) 0.092*** 0.092*** 0.050*** 0.090*** 0.088*** 0.053***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Operating Leverage 0.220*** 0.221*** 0.069*** 0.192*** 0.194*** 0.056***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Herfindahl Index 0.520*** 0.519*** 0.138** 0.241* 0.243* 0.062
(0.000) (0.000) (0.016) (0.096) (0.090) (0.286)
Intercept -0.109*** -0.124*** -0.026** -0.285*** -0.309*** -0.059***
(0.003) (0.002) (0.033) (0.000) (0.000) (0.000)
Year Dummies Yes Yes Yes Yes Yes Yes
Industry-median-adjusted Firm-
Yes Yes Yes Yes Yes Yes
level Variables
Observations 24,279 24,279 96,818 24,279 24,279 96,818
R2 0.283 0.283 0.333 0.266 0.265 0.327

Hansen's J-test (p-value): 0.220 0.269 0.784

First-stage Shea partial R-square for Leverage: 0.257 0.267 0.201
First-stage Shea partial R-square for the interaction term: 0.286 0.288 0.235
 TABLE 7
Economic Significance
This table presents changes in Output per Employee and Imputed Firm Value when Leverage, outside
employment opportunities and other control variables change from the 25 th percentile to the 75th percentile based
on the OLS and 2SLS estimates of models in Table 3 and Table 6. The sample is from the Compustat database for
2000-2007 and excludes firms with no debt or debt ratios above the 90th percentile (0.658). Quit Rate is the
number of employees in an industry that voluntarily quit their jobs divided by the total number of employees in
the industry. Hire rate is the total number of new hires in an industry divided by the total number of employees.
We set all control variables to their mean values and vary only the variable of interest. Output per Employee
equals sales plus changes in inventories divided by the number of employees. Imputed Firm Value equals Output
per Employee multiplied by the industry median of firm value per unit of employee productivity. Firm value is
the market value of equity plus book value of debt. For estimations based on OLS results, Leverage is the ratio of
book value of debt divided by the sum of book value of debt plus market value of common equity. For
estimations based on the 2SLS results, Leverage is the predicted Leverage from the first stage of 2SLS
estimation. The economic significance for control variables are based on the estimates from the Quit Rate
regressions. Employees is the number of employees reported in Compustat. Asset Intensity is total assets divided
by the number of employees. Firm Age is the number of years the firm appears in Compustat. Profitability is the
ratio of operating earnings to assets. Operating Leverage is gross Property, Plant & Equipment divided by total
assets.

Panel A. Changes in productivity when Leverage changes from 25 th to 75th percentile

Change in output per Change in imputed firm Change in imputed firm
employee (%) value ($m) value (%)
When outside options are 25th 75th 25th 75th 25th 75th
held at: Percentile Percentile Percentile Percentile Percentile Percentile
Quit Rate (OLS) 8.52 4.54 12.01 6.53 9.14 4.99
Hire Rate (OLS) 9.46 3.85 13.13 5.49 10.01 4.17
Quit Rate (2SLS) 11.44 6.97 16.72 10.28 12.58 7.75
Hire Rate (2SLS) 11.56 6.45 17.51 9.84 13.18 7.42
th th
Panel B. Changes in productivity when control variables change from 25 to 75 percentile
Change in output per Change in imputed firm Change in imputed firm
employee (%) value ($m) value (%)
OLS 2SLS OLS 2SLS OLS 2SLS
Ln(Employees) 6.90 6.13 9.08 10.32 6.90 7.63
Ln(Asset Intensity) 42.31 42.22 47.26 48.28 43.12 43.03
Ln(Firm Age) 7.29 7.13 9.70 9.71 7.37 7.21
Operating Leverage 6.81 5.97 9.30 8.34 7.10 6.19
 TABLE 8
Employ Productivity, Leverage, and Outside Employment Opportunities: Industry Level Regressions
This table presents OLS results from the regressions on the industry level. The sample is from the Compustat
database for 1976-2007 and excludes firms with no debt or debt ratios above the 90th percentile (0.658). All
variables equal their respective industry medians (based on 2-digit SIC codes) in each year. The dependent variable
is the natural log of Output per Employee, which is sales plus change in inventories divided by the number of
employees. Leverage is the ratio of book value of debt divided by the sum of book value of debt plus market value
of common equity. Leverage and the product of Leverage*Outside Employment Opportunities are the predicted
values from the first stage. Quit Rate is the number of employees in an industry that voluntarily quit their jobs
divided by the total number of employees in the industry. Hire rate is the total number of new hires in an industry
divided by the total number of employees. Quit Rate and Hire Rate are available for 2000-2007. Unemployment
Growth Rate is the growth rate of the unemployment rate by industry. Employees is the number of employees
reported in Compustat. Asset Intensity is total assets divided by the number of employees. Firm Age is the number
of years the firm appears in Compustat. Operating Leverage is gross Property, Plant & Equipment divided by total
assets. *** significant at 1% level; ** significant at 5% level; * significant at 10% level.

Unemployment
Quit Rate Hire Rate Growth Rate
Leverage 0.918*** 0.837** 0.412***
(0.009) (0.037) (0.000)
Leverage * Outside Employment -0.336** -0.157* 1.055**
Opportunities (0.010) (0.069) (0.047)
Outside Employment Opp. 0.068 0.026 -0.345**
(0.182) (0.341) (0.047)
Ln(Employees) 0.101*** 0.098*** 0.115***
(0.000) (0.000) (0.000)
Ln(Asset Intensity) 0.688*** 0.690*** 0.665***
(0.000) (0.000) (0.000)
Ln(Firm Age) 0.075 0.084 0.148***
(0.281) (0.229) (0.000)
Operating Leverage -0.574*** -0.584*** -0.717***
(0.000) (0.000) (0.000)
Herfindahl Index 0.171* 0.170* -0.097
(0.065) (0.066) (0.350)
Intercept 1.375*** 1.401*** 1.729***
(0.000) (0.000) (0.000)
Year Dummies Yes Yes Yes
Observations 460 460 1,776
2
R 0.717 0.715 0.669
 TABLE 9
Employee Productivity, Leverage, and Outside Employment Opportunities: Alternative Models
This table presents the 2SLS results of the impact of outside employment opportunities on the productivity-leverage
relation using two alternative model specifications. In the quadratic form specification, we include Leverage2 and
Leverage2×Outside Employment Opportunities in the model. The sample is from the Compustat database for 1976-
2007 and excludes firms with no debt. In the model with additional control variables, we include Union
Membership, Best Company dummy, Defined Benefits Plan dummy, Industry Weekly Earnings, and Institutional
Block Ownership. The sample with additional control variables excludes firms with no debt or debt ratios above the
90th percentile (0.658). The dependent variable is the natural log of Output per Employee, which we define as sales
plus changes in inventories divided by the number of employees. The instrumental variables for Leverage are the
median leverage of the firm’s industry and the firm’s asset beta. Leverage, Leverage2 and the products of
Leverage×Outside Employment Opportunities and Leverage2×Outside Employment Opportunities are the predicted
values from the first stage. Refer to Table 1 for definitions of the additional control variables. Except for predicted
Leverage related variables, we adjust all continuous firm-level variables for the respective industry median in each
year. We present p-values, adjusted for heteroskedasticity and firm clustering, in parentheses. *** significant at 1%
level; ** significant at 5% level; * significant at 10% level.
Quadratic Form Additional Control Variables
Unemployment Unemployment
Quit Rate Hire Rate Growth Rate Quit Rate Hire Rate Growth Rate
Leverage 2.916*** 3.255*** 1.189*** 1.204*** 1.351*** 0.485***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Leverage2 -3.037*** -3.332*** -1.436***
(0.000) (0.000) (0.000)
Leverage * Outside Employment -0.714** -0.465*** 1.059*** -0.273*** -0.181*** 0.441***
Opportunities (0.012) (0.005) (0.000) (0.001) (0.000) (0.000)
Leverage2 * Outside Employment 0.759** 0.477** -1.093***
Opportunities (0.027) (0.020) (0.004)
Outside Employment Opp. 0.083** 0.053*** -0.162*** 0.048** 0.031** -0.106***
(0.012) (0.004) (0.000) (0.024) (0.012) (0.000)
Union Membership -0.001 -0.001 0.000
(0.479) (0.532) (0.978)
Best Co. (0/1) 0.308*** 0.310*** 0.256***
(0.000) (0.000) (0.000)
Defined Benefits Plan (0/1) 0.047** 0.041** 0.036**
(0.011) (0.031) (0.028)
Institutional Block Ownership 0.060 0.056 0.049
(0.220) (0.252) (0.256)
Ln(Industry weekly earnings) -0.001 -0.005 0.027
(0.961) (0.805) (0.123)
Ln(Employees) 0.016*** 0.017*** 0.015*** 0.017*** 0.018*** 0.015***
(0.001) (0.000) (0.000) (0.001) (0.001) (0.001)
Ln(Asset Intensity) 0.525*** 0.526*** 0.549*** 0.516*** 0.517*** 0.530***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Ln(Firm Age) 0.078*** 0.076*** 0.053*** 0.082*** 0.082*** 0.074***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Operating Leverage 0.176*** 0.179*** 0.043*** 0.184*** 0.186*** 0.135***
(0.000) (0.000) (0.004) (0.000) (0.000) (0.000)
(Continued on next page)
 TABLE 9 (continued)
Employee Productivity, Leverage, and Outside Employment Opportunities: Alternative Models
Herfindahl Index 0.199 0.219* 0.045 0.207 0.207 0.199*
(0.129) (0.091) (0.393) (0.151) (0.147) (0.093)
Intercept -0.394*** -0.431*** -0.130*** -0.273** -0.267** -0.310***
(0.000) (0.000) (0.000) (0.047) (0.046) (0.010)

Year Dummies Yes Yes Yes Yes Yes Yes

Industry-median-adjusted Firm-level
Variables Yes Yes Yes Yes Yes Yes
Observations 26,779 26,779 107,700 24,279 24,279 30,637
R2 0.287 0.287 0.339 0.282 0.281 0.313

Hansen's J-test (p-value): 0.116 0.141 0.441 0.128 0.156 0.094

First-stage Shea partial R-square for
Leverage: 0.093 0.093 0.068 0.237 0.232 0.171
First-stage Shea partial R-square for
Leverage2: 0.081 0.080 0.058
First-stage Shea partial R-square for
the interaction term of Leverage: 0.100 0.102 0.084 0.281 0.272 0.234
First-stage Shea partial R-square for
the interaction term of Leverage2: 0.089 0.088 0.072
 TABLE 10
EBITDA per Employee, Financial Leverage, and Outside Employment Opportunities
This table presents the 2SLS results of the impact of outside employment opportunities on the productivity-leverage
using EBITDA per employee to measure productivity. The sample is from the Compustat database for 1976-2007
and excludes firms with no debt or debt ratios above the 90th percentile (0.658). The dependent variable is EBITDA
per Employee, which is the ratio of operating income before depreciation and amortization to the number of
employees. Leverage is the ratio of book value of debt divided by the sum of book value of debt plus market value
of common equity. The instrumental variables for Leverage are the median leverage of the firm’s industry and the
firm’s asset beta. Leverage and the product of Leverage*Outside Employment Opportunities are the predicted
values from the first stage. Quit Rate is the number of employees in an industry that voluntarily quit their jobs
divided by the total number of employees in the industry. Hire rate is the total number of new hires in an industry
divided by the total number of employees. Quit Rate and Hire Rate are available for 2000-2007. Unemployment
Growth Rate is the growth rate of the unemployment rate by industry. Employees is the number of employees
reported in Compustat. Asset Intensity is total assets divided by the number of employees. Firm Age is the number
of years the firm appears in Compustat. Operating Leverage is gross Property, Plant & Equipment divided by total
assets. The Herfindahl Index for a 2-digit SIC code industry is the sum of the squared market share of each firm in
that industry. Except for Leverage- related variables, we adjust all continuous firm-level variables for their industry
median in the year. We present p-values, adjusted for heteroskedasticity and firm clustering, in parentheses. ***
significant at 1% level; ** significant at 5% level; * significant at 10% level.
Unemployment
Quit Rate Hire Rate Growth Rate
Leverage 254.125*** 255.117*** 33.476***
(0.000) (0.000) (0.000)
Leverage * Outside Employment Opportunities -44.083*** -21.796** 22.664*
(0.002) (0.016) (0.098)
Outside Employment Opportunities 5.577 5.210** -6.809*
(0.112) (0.013) (0.050)
Ln(Employees) 3.126*** 3.185*** 2.506***
(0.004) (0.003) (0.000)
Ln(Asset Intensity) 75.755*** 75.741*** 66.722***
(0.000) (0.000) (0.000)
Ln(Firm Age) 10.761*** 10.288*** 5.179***
(0.002) (0.003) (0.001)
Operating Leverage 53.261*** 52.888*** 21.884***
(0.000) (0.000) (0.000)
Herfindahl Index -55.527 -72.040** 3.522
(0.103) (0.037) (0.658)
Intercept -9.000 -17.207* 27.591***
(0.322) (0.076) (0.000)
Year Dummies Yes Yes Yes
Industry-median-adjusted Firm-level Variables Yes Yes Yes
Observations 24,279 24,279 96,818
R2 0.111 0.110 0.162

Hansen's J-test (p-value): 0.427 0.306 0.101

2
First-stage Shea partial R for Leverage: 0.257 0.257 0.201
2
First-stage Shea partial R for the interaction term of Leverage: 0.286 0.288 0.235
 TABLE 11
Employee Productivity, Leverage, and Outside Employment Opportunities: Alternative Samples I

This table presents 2SLS results of the impact of outside employment opportunities on the productivity-leverage
relation using two alternative samples from the Compustat database for 1976-2007. The first sample includes zero-
debt firms and excludes firms with debt ratios above the 90th percentile (0.658). The second sample excludes zero-
debt firms and firms with debt ratios above the 75th percentile (0.446). The dependent variable is the natural log of
Output per Employee, which is sales plus changes in inventories divided by the number of employees. Leverage is
the ratio of book value of debt divided by the sum of book value of debt plus market value of common equity. The
instrumental variables for Leverage are the median leverage of the firm’s industry and the firm’s asset beta.
Leverage and the product of Leverage*Outside Employment Opportunities are the predicted values from the first
stage. Quit Rate is the number of employees in an industry that voluntarily quit their jobs divided by the total
number of employees in the industry. Hire rate is the total number of new hires in an industry divided by the total
number of employees. Quit Rate and Hire Rate are available for 2000-2007. Unemployment Growth Rate is the
growth rate of the unemployment rate. Table 1 presents definitions for other variables. Except for leverage
variables, we adjust all continuous firm-level variables for their respective industry medians in each year to control
for industry effects. We present p-values, adjusted for heteroskedasticity and firm clustering, in parentheses. ***
significant at 1% level; ** significant at 5% level; * significant at 10% level.

Excludes Firms in
Includes Zero Debt Firms the Top Leverage Quartile
Unemployment Unemployment
Quit Rate Hire Rate Growth Rate Quit Rate Hire Rate Growth Rate
Leverage 1.436*** 1.566*** 0.333*** 2.259*** 2.429*** 0.678***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Leverage * Outside Employment -0.395*** -0.240*** 0.304*** -0.561*** -0.338*** 0.454***
Opportunities (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Outside Employment Opp. 0.064*** 0.037*** -0.094*** 0.081*** 0.047*** -0.105***
(0.000) (0.000) (0.000) (0.002) (0.001) (0.000)
Ln(Employees) 0.031*** 0.031*** 0.027*** 0.024*** 0.024*** 0.026***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Ln(Asset Intensity) 0.517*** 0.517*** 0.539*** 0.513*** 0.514*** 0.538***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Ln(Firm Age) 0.087*** 0.085*** 0.049*** 0.090*** 0.089*** 0.059***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Operating Leverage 0.193*** 0.195*** 0.061*** 0.174*** 0.175*** 0.044**
(0.000) (0.000) (0.000) (0.000) (0.000) (0.011)
Herfindahl Index 0.468*** 0.470*** 0.099* 0.296* 0.305** 0.093
(0.001) (0.001) (0.078) (0.058) (0.048) (0.151)
Intercept -0.305*** -0.318*** -0.074*** -0.380*** -0.399*** -0.108***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Year Dummies Yes Yes Yes Yes Yes Yes
Industry-median-adjusted Firm-
Yes Yes Yes Yes Yes Yes
level Variables
Observations 30,325 30,325 110,759 21,285 21,285 80,477
R2 0.256 0.257 0.313 0.253 0.253 0.313
Hansen's J-test (p-value) 0.562 0.655 0.597 0.449 0.500 0.539
First-stage Shea partial R-square
0.278 0.276 0.200 0.205 0.201 0.148
for Leverage
First-stage partial R-square for the 0.309 0.312 0.256 0.227 0.222 0.186
interaction term of Leverage:
 TABLE 12
Employee Productivity, Leverage, and Outside Employment Opportunities: Alternative Samples II
This table presents 2SLS results of the impact of outside employment opportunities on the productivity-leverage
relation using two alternative samples from the Compustat database for 1976-2007. We exclude firms with zero debt
or a debt ratio above the 90th percentile (0.658). The first sample excludes firms that report M&A impact on sales.
The second sample excludes firms in the top (> 15,402) and bottom (< 62) deciles by number of employees. The
dependent variable is the natural log of Output per Employee, which is sales plus change in inventories divided by
the number of employees. Leverage is the ratio of book value of debt divided by the sum of book value of debt plus
market value of common equity. The instrumental variables for Leverage are the median leverage of the firm’s
industry and the firm’s asset beta. Leverage and the product of Leverage*Outside Employment Opportunities are the
predicted values from the first stage. Quit Rate is the number of employees in an industry that voluntarily quit their
jobs divided by the number of employees in the industry. Hire rate is the number of new hires in an industry divided
by the number of employees. Quit Rate and Hire Rate are available for 2000-2007. Unemployment Growth Rate is
the growth rate of the industry unemployment rate. Table 1 presents definitions for other variables. Except for
leverage variables, we adjust all continuous firm-level variables for industry medians in each year to control for
industry effects. We present p-values, adjusted for heteroskedasticity and firm clustering, in parentheses. ***
significant at 1% level; ** significant at 5% level; * significant at 10% level.

Excludes Firms in the Top and Bottom

Deciles by Number of Employees Alternative Control for M&A Events
Unemployment Unemployment
Quit Rate Hire Rate Growth Rate Quit Rate Hire Rate Growth Rate
Leverage 1.181*** 1.306*** 0.209*** 1.566*** 1.741*** 0.447***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Leverage * Outside Employment -0.256*** -0.168*** 0.413*** -0.391*** -0.251*** 0.176**
Opportunities (0.003) (0.001) (0.000) (0.000) (0.000) (0.030)
Outside Employment Opp. 0.054** 0.031*** -0.110*** 0.072*** 0.045*** -0.055**
(0.013) (0.009) (0.000) (0.002) (0.001) (0.010)
Ln(Employees) 0.017*** 0.017*** 0.013*** 0.030*** 0.031*** 0.029***
(0.002) (0.001) (0.000) (0.000) (0.000) (0.000)
Ln(Asset Intensity) 0.524*** 0.525*** 0.555*** 0.511*** 0.512*** 0.533***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Ln(Firm Age) 0.095*** 0.094*** 0.064*** 0.091*** 0.088*** 0.058***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Profitability 0.191*** 0.193*** 0.033** 0.173*** 0.174*** 0.040**
(0.000) (0.000) (0.040) (0.000) (0.000) (0.015)
Operating Leverage 0.144 0.156 0.030 0.354** 0.356** 0.083
(0.372) (0.327) (0.600) (0.019) (0.017) (0.159)
Herfindahl Index -0.227*** -0.239*** 0.002 -0.341*** -0.368*** -0.087***
(0.000) (0.000) (0.881) (0.000) (0.000) (0.000)
Intercept 1.181*** 1.306*** 0.209*** 1.566*** 1.741*** 0.447***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Year Dummies Yes Yes Yes Yes Yes Yes
Industry-median-adjusted Firm-
Yes Yes Yes Yes Yes Yes
level Variables
Observations 19,418 19,418 77,398 21,812 21,812 87,817
R2 0.302 0.302 0.384 0.255 0.255 0.307
Hansen's J-test (p-value) 0.044 0.061 0.116 0.114 0.147 0.436
First-stage Shea partial R-square
0.262 0.259 0.202 0.255 0.254 0.198
for Leverage
First-stage partial R-square for the
0.285 0.282 0.235 0.286 0.287 0.232
interaction term of Leverage: