Human Capital and Investment Policy

Abstract

The literature relates human capital costs to firm leverage (Berk, Stanton, and Zechner (2010) and Chemmanur, Cheng, and Zhang (2013)) and mergers and acquisitions (Lee, Mauer, and Xu (2017)). In this paper, we study the relation between a firm’s human capital costs and investment policy. We argue that employees demand higher pay to compensate for the additional unemployment risk borne by firm’s investment riskiness. We first present a simple theoretical setting to illustrate the positive effects of investment riskiness on average employee pay. We then empirically examine the relation. We find a significantly positive relation between investment riskiness (as proxied by cash flow volatility and unlevered stock return volatility) and human capital cost (as measured by CEO compensation and average employee pay). The effect is stronger in low-pay firms than high-pay firms, and non-technology firms than technology firms. We further investigate four channels through which investment riskiness possibly influence human capital costs: corporate diversification, R&D expenditures, advertising expenditures, and total value of acquisitions in a year. We find that while diversification negatively affects human capital cost, the rest of the three channels have positive effect on human capital costs. Lastly, we show that firms adjust their investment policy based on labor intensity. Our results are robust after accounting for the endogeneity concerns. Overall, our research contributes to the nascent but growing literature on the impact of human capital on firm decisions.