Abstract
We show that corporate bankruptcy leads to a significant reduction in employee earnings, which in turn increases financial distress costs for firms via higher ex ante wages. Annual employee earnings deteriorate by 10% when a firm files for bankruptcy and remain below pre-bankruptcy earnings for at least six years. Affected employees are likely to work fewer hours and leave the firm, industry, and local labor market. We estimate that compensating wage differentials for this “bankruptcy risk” increase the present value of ex ante wages paid by the firm by up to 12% of annual wages. Overall, this paper shows that bankruptcy risk reduces risk-sharing between the firm and workers, and the resulting additional labor costs are large enough to be a first-order consideration in corporate capital structure decisions.
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