Market Reactions To Company Layoffs: Evidence On The Financial Distress Versus Potential Benefit Hypothesis And The Effect Of Predisclosure Information

Abstract

The current study extends theory developed by Malatesta and Thompson (1985) to the area of corporate downsizing, and finds that the magnitude of the stock price reaction to announcements of corporate layoffs is a function of two factors, (1) the economic impact of the announced layoff, and, (2) the degree to which the announcement and signal about the underlying conditions related to the announcement have been anticipated by investors and incorporated previously into the stock price (predisclosure information).

For firms experiencing a negative overall stock price reaction at the date of a layoff announcement, the larger the layoff (proxy for economic impact), the more negative the stock price reaction. Also for these firms, the smaller the firm size (proxy for the level of predisclosure information), the more negative the stock price reaction. This provides evidence that for some firms, the financial distress effect dominates, and the market incorporates previously unknown negative information into the stock price, which results in the negative stock price reaction. For these firms, the larger the impact and the less the event is anticipated, the more negative is the stock price reaction.

For firms experiencing a positive overall stock price reaction at the date of a layoff announcement, the larger the layoff (proxy for economic impact), the more positive the stock price reaction. Also for these firms, the smaller the firm size (proxy for level of predisclosure information), the more positive the stock price reaction. This provides evidence that for some firms, the potential benefit effect dominates. The market has previously incorporated negative information associated with the conditions leading up the layoff, and is now incorporating positive information about the benefits to be achieved by the layoff, which results in the positive stock price reaction. For these firms, the larger the impact and the less the event is anticipated, the more positive is the stock price reaction.

In this study, hypotheses are developed which combine the effects of both economic impact and predisclosure information with the financial distress and potential benefit hypotheses developed in prior research in corporate downsizing. Instead of offering the these two hypotheses as competing and mutually exclusive, evidence is provided that supports the conclusion that these hypotheses simultaneously explain concurrent and additive effects on the stock price reaction to announcements of company layoffs. Finally, results indicate that the relationship between economic impact, predisclosure information and stock price reaction to layoff announcements depends on the relative dominance of the signals provided by the layoff about both financial distress and potential benefit.