Abstract
An employee’s annual earnings fall by 10% the year her firm files for bankruptcy and fall by a cumulative present value of 67% over seven years. This effect is more pronounced in thin labor markets and among small firms that are ultimately liquidated. Compensating wage differentials for this “bankruptcy risk” are approximately 2.3% of firm value for a firm whose credit rating falls from AA to BBB, about the same magnitude as debt tax benefits. Thus, wage premia for expected costs of bankruptcy are of sufficient magnitude to be an important consideration in corporate capital structure decisions.
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