A Theoretical And Empirical Investigation Of The Impact Of Labor Flexibility On Risk And The Cost Of Equity Capital

Abstract

This paper analytically and empirically investigates the linkage between labor costs and a firm’s income volatility, equity risk, and cost of capital. While the relationship between labor costs and the firm’s cost of capital under uncertainty conditions is important, there has been little research examining this issue. While we control for fixed labor costs, we focus on labor flexibility effects as the U.S. temporary staffing sales for 2005 totaled $69.5 billion, 8.5% more than in the previous year (American Staffing Association, 2007). Within the Capital Asset Pricing Model (CAPM) framework, we demonstrate analytically and empirically that labor flexibility reduces income volatility, equity risk and cost of capital in the service industry. However, we find that labor leverage has no impact on income volatility, and increases equity risk and cost of equity capital. These results suggest that managers can structure labor costs to minimize the firm’s risk and maximize shareholder value.