A Structural Model of Human Capital and Leverage - Duke ...

1 Introduction
Quantitatively, human capital is the most important factor of production. On average roughly two-thirds of
firm output is used to compensate its labor force. Yet despite its quantitative significance, labor has received
relatively little attention in the corporate finance literature. When explicitly modeled, labor typically takes
the form of a manager who controls a project and must be properly incentivized by the project’s owners.
The study of the problem of the separation of ownership and control is central in corporate finance and
has led to, among other things, a large literature on executive compensation. This focus on key managerial
employees, however, ignores a much larger group of employees who have neither significant ownership nor
control individually, but who collectively are tremendously important to the success of the firm.
Typically, labor is implicitly treated as a purely variable factor of production. When labor markets are
frictionless employees can be hired and fired costlessly and always earn their marginal product. In such a
setting labor has no effect on firm value or firm policies. In the presence of labor market frictions, however,
labor becomes a quasi-fixed factor of production and contributes to firm value. Such frictions may include
the inability of workers to insure their labor income, costly search and matching, or the acquisition of firm-
specific human capital. With frictional labor markets there is a match-specific surplus associated with the
employment relationship, which must be divided between workers and employees. Workers are better off if
they can keep their current jobs, and firms are better off if they can keep their current employees. When
part of the value of the firm comes from rents earned from labor, a value maximizing firm will consider the
effect of its policies on labor. Corporate policies may affect the firm’s labor expenses and its ability to retain
workers, which in turn affect firm value. Such policies may include capital structure, dividend policy, cash
management, corporate governance, investment, mergers and acquisitions, etc.
Recently a literature has emerged that studies the interaction between labor markets and corporate
finance. This literature presents mounting evidence that human capital has an important impact on corporate
policies. Despite this evidence, to the best of my knowledge no dynamic model of labor and corporate finance
currently exists. The purpose of this paper is to fill this gap, formalizing the way in which we think about
the effect of labor markets on corporate finance and providing a lens through which to interpret recent
contributions to this literature. I focus on the interaction between human capital and capital structure. I
augment a standard neoclassical model of the firm to include a simple model of job search. Since workers who
are laid off cannot find alternative employment immediately, unemployment is costly to workers. Leverage
exposes workers to unemployment risk, for which they are compensated ex ante through higher wages.
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