Corporate Employment and Cash Flow Uncertainty. Sanjai Bhagat and Iulian Obreja University of Colorado at Boulder. Abstract

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1 Corporate Employment and Cash Flow Sanjai Bhagat and Iulian Obreja University of Colorado at Boulder Abstract We highlight the role of cash flow uncertainty on corporate employment and corporate investment in both tangible and intangible assets. We find that cash flow uncertainty has a significantly negative impact on corporate employment and corporate investment in both tangible and intangible assets. If cash flow uncertainty were to revert to levels observed back in 2005, corporate employment would increase by more than 1.9 million jobs. Furthermore, we document that cash flow uncertainty has had a more negative impact on corporate employment and corporate investment in tangible and intangible assets during economic recessions than during economic expansions. These findings have significant policy implications. To wit, if policy makers would like corporations to increase their employment and investment, they should focus on policies that decrease corporate cash flow uncertainty. February 2012 This is based on our earlier, much longer and technical paper, Employment, Corporate Investment and Cash Flow, Available at SSRN: or 1

2 Corporate Employment and Cash Flow An important stylized fact of the U.S. aggregate corporate activity is that corporate investment declines rapidly in the period leading to an economic recession, but rebounds equally rapidly in the period following a recession. For instance, corporate investment reached pre-recession levels within 2-3 years following the recessions of 1991 and However, the late economic recession of challenged this stylized empirical fact, as corporate investment post-recession grew painfully slow and failed to rebound to prerecession levels. This observation has puzzled economist and policy makers alike because it is not immediately clear what causes the delay in corporate investment. For instance, a typical bottleneck known to preclude firms from pursuing growth opportunities is access to capital. However, in the aftermath of the 2008 financial crisis, the efforts of policy makers to resuscitate the credit channel failed to jump start corporate investment. Given the direct and indirect effects of corporate investment in increasing employment, corporate investment is understandably of critical policy importance. Corporate investment policy has been studied by corporate finance scholars for the better part of the past century. The net present value investment decision rule is a wellaccepted paradigm. In the traditional paradigm, larger expected cash flows impact positively corporate investment, while larger corporate cash flow uncertainty impact negatively corporate investment. In this paper we highlight the impact of corporate cash flow uncertainty on corporate investment. Our measure of corporate cash flow uncertainty is based on the S&P 500 volatility index. We consider three measures of corporate investment: 2

3 Corporate investment in human capital, more specifically, employment change (change in number of employees from past year divided by the past year number of employees). Corporate investment in intangible assets like patent, brand name, goodwill, and customer lists. Corporate investment in tangible assets like plant, property and equipment. We find that corporate cash flow uncertainty has a negative impact on corporate employment change, corporate investment in intangible assets and tangible assets. Furthermore, the impact is more negative during economic recessions compared to economic expansions. More precisely, a 10% increase in corporate cash flow uncertainty lowers employment change by 67% during economic recessions and 16% during economic expansions. A 10% increase in corporate cash flow uncertainty lowers investment in intangible assets by 3% during economic recessions and 2% during economic expansions. A 10% increase in corporate cash flow uncertainty lowers investment in tangible assets by 1.4% during economic recessions and 1% during economic expansions. Table 1 summarizes the impact of increase in corporate cash flow uncertainty on different measures of corporate investment. 3

4 Table 1: Impact of Increase in Corporate Cash Flow on different measures of Corporate Investment Impact of 10 % Increase in Corporate Cash Flow on Employment change Investment in intangible assets Investment in intangible assets During economic recessions 67% 3% 1.4% During economic expansions 16% 2% 1% Corporate cash flow uncertainty is based on the S&P 500 volatility index. Employment change is the change in number of employees from past year divided by the past year number of employees. Our measure of corporate cash flow uncertainty is based on the S&P 500 volatility index. Alternative measures of macroeconomic uncertainty are proposed by Baker, Bloom and Davis ( Measuring Economic Policy, Stanford University and NBER working paper, 2012, available at Their measures are constructed from the frequency of references to policy-related economic uncertainty in the Google-media catalog, the number of tax measures set to expire in future years, and finally, the dispersion among economic forecasters about government spending and CPI price level. Table 2 summarizes the correlations between various uncertainty measures. 4

5 Table 2: Correlations between various uncertainty measures for measure based on S&P 500 volatility measure based on Index of Economic Policy measure based on Index of News- Based Policy measure based on S&P 500 volatility measure based on Index of Economic Policy measure based on Index of News-Based Policy Index of News-Based Policy : From Baker, Bloom and Davis (2011): Monthly number of news articles in Google containing uncertainty and economy. Index of Economic Policy : From Baker, Bloom and Davis (2011): Includes weighted average of Index of News-Based Policy, number of tax laws expiring, and disagreements about one-year CPI and federal government expenditures. Table 1 notes that a 10% increase in corporate cash flow uncertainty decreases corporate employment by 67% during a recession. To provide a perspective on this 67% figure we convert this to the estimated increase in additional U.S. national employment (in millions of workers) if uncertainty measure were lower as in three different benchmark years, namely, 1996, 2005, and 2006; see Table 3. For example, we find that U.S. national employment would increase by 1.9 million to 2.1 million jobs if the cash flow uncertainty were to decrease to 2005 levels. 5

6 Table 3: Increase in additional U.S. national employment (in millions of workers) if uncertainty measure were lower measure based on S&P 500 volatility measure based on Index of Economic Policy measure based on Index of News-Based Policy Increase in additional U.S. national employment (in millions of workers) if uncertainty measure were lower as in the following normal years Index of News-Based Policy : From Baker, Bloom and Davis (2011): Monthly number of news articles in Google containing uncertainty and economy. Index of Economic Policy : From Baker, Bloom and Davis (2011): Includes weighted average of Index of News-Based Policy, number of tax laws expiring, and disagreements about one-year CPI and federal government expenditures. Summary and Recommendations Our evidence suggests that corporate employment and corporate investment in tangible and intangible assets are negatively impacted by cash flow uncertainty, and this effect is more pronounced in economic recessions. Our results suggest that the extent to which corporate investment rebounds after an economic recession depends on firms' perception about cash flow uncertainty. If firms perceive future cash flows as risky they will postpone investment and post-recession corporate investment will take longer to rebound. Our empirical findings 6

7 show that not all recessions are alike. For instance, cash flow uncertainty during the postrecession periods and declines rapidly (see Figure 1) and, consequently, investment including employment bounces back rapidly. However, cash flow uncertainty during the post-recession period has declined very slowly, and consequently corporate investment including corporate employment increases very modestly. These findings have significant policy implications; if policy makers would like corporations to increase their hiring and investment activity, they should focus on policies that decrease corporate cash flow uncertainty. Specifically, to the extent corporations are uncertain about the implementation and the implementation-timeline of the health reform act, and the impact of this act on their costs of hiring and retaining employees - a clarification of the implementation and the implementation-timeline of the health reform act would encourage corporations to invest more and hire more employees. Similarly, to the extent corporations are uncertain about the implementation and the implementation-timeline of the environmental cap-and-trade reform and corporate tax reforms - a clarification of the implementation and the implementation-timeline of these environmental and tax reforms would encourage corporations to invest more and hire more employees. 7

8 Figure 1: Corporate Employment Change and Cash Flow 8