The Effect Of A Firm's Financial Condition On The Market Reaction To Company Layoffs

Abstract

Prior research has presented two conflicting hypotheses regarding the effect of a firm's financial condition on the market reaction to announcements of company layoffs. The "financial distress" hypothesis states that the market reaction to layoffs for financially weak firms will be more negative than for financially healthy firms, because the layoff announcement reveals and/or confirms the problems that led to the layoff. On the other hand, the "potential benefit" hypothesis states that the market reaction for financially weak firms will be more positive than for financially healthy firms, because the financially weak firms have a greater potential to benefit from the layoff. Two prior studies, Iqbal and Shetty (1995) and Worrell, Davidson, and Sharma (1991), examine stock price reactions to announcements of company layoffs and how those reactions are related to the financial condition of the firm at the time of the layoff. They reach different conclusions, however, as to the effect of financial condition. Iqbal and Shetty find evidence supporting the potential benefit hypothesis, whereas WDS find evidence supporting the financial distress hypothesis.

The current study offers an alternative hypothesis for the effect of a firm's financial condition on the market reaction to layoffs. Instead of concluding that the financial distress and potential benefit hypotheses are mutually exclusive and competing, this study provides evidence that these hypotheses simultaneously explain concurrent and additive effects on the stock price reactions to layoff announcements. These results have implications both for investors and management regarding the market's reaction to announcements of employee layoffs.