Downsizing Term Paper

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The economy was strong, inflation was falling, and real GNP was growing at a steady, confident pace. Corporate profits had reached historically high

levels, and investors were on a buying spree in the stock market, pushing it from one record close to the next. Unemployment had fallen to a level that

many economists felt was consistent with non-accelerating inflation. Expectations of inflation were abated, and the boom seemed to be poised to last

for a long time, with no economic downturn in sight. At the same time, the major corporations in the US appeared to be firing workers by the

hundreds of thousands, and job insecurity had risen to a surprisingly high level. Regardless of seniority, the company\'s profitability, or the surging

demand for the firm\'s outputs, the threat to an employee of finding a pink slip in the next pay envelope was real and widespread. No job seemed safe.

The above statements, describing the US economy in the mid 1990s, seem inconsistent not only with a standard textbook characterization of an

economic boom, but also with any historically observable relationship between the labor market and other economic arenas, such as the financial market

or the goods market. Politicians and unions pointed to the greed of corporate America, and the insensitivity of management to the contributions and

value of workers. Standard microeconomics was at a complete loss to explain the phenomenon. If strong firms were anticipating a greater demand for

their products during the economic boom, and labor costs were not rising excessively relative to productivity, why were firms firing workers? The term

\"downsizing\" was coined to describe the action of dismissing a large portion of a firm\'s workforce in a very short period of time, particularly when the

firm was highly profitable.

In a standard downsizing story, a profitable firm well-poised for growth would announce that it was firing a large percentage of its workforce. The

equity market would get excited, and initiate a buying frenzy of the firm\'s stock. This goes counter to a standard micro-economic analysis, in which a

weak firm anticipates a slump in the demand for its products, and lays off workers, while a strong firm foresees a jump in the demand for its products,

and hires more workers to increase production.

Investors care about downsizing, since it contains severe implications for the short-term profitability and even the long-term growth of a company. A

downsizing is quite unlike a traditional layoff: in a layoff, a worker is asked to temporarily leave during periods of weak demand, but will be asked back

when business picks up. In a downsizing, the separation between a worker and a firm is permanent. A downsizing is also not a dismissal for individual

incompetence, but rather a decision on the part of management to reduce the overall work force.

Through a downsizing, the management inadvertently (or perhaps deliberately) signals to investors what the future economic health of the firm is. In

the 1980s, the largest layoffs were executed by weak companies, who were losing market share to foreign firms, or had large drops in demand for their

products. Downsizings were clearly regrettable, but understandable, as they helped the firms to survive. Such a large amount of workers was certainly

unnecessary for a firm doing a smaller volume of sales, so the workers were released in large numbers over short intervals of time. Investors noticed

that major layoffs were taking place, and downgraded their expectations of the firm\'s future profitability, so they dumped the stock. Yet, this perfectly

logical explanation seems inconsistent with what was actually taking place in corporate boardrooms and on the trading floors of the New York Stock

Exchange of the 1990s: the companies ridding themselves of workers by the thousands were strong, and had bright economic futures ahead of them.

Upon learning of downsizings, the alleged signals of firm weakness, investors went on a buying spree, and sent the company\'s stock price soaring. This

paradox leads to the first two questions addressed in this thesis:

1.Why does the value of a firm increase when it announces a downsizing, especially since downsizing is supposedly a signal of rough economic times ahead?

2.Why do strong firms lay off workers in a boom, but not in a recession?

Another simultaneous-and possibly related-phenomenon in the 1990s is the popularity of a new form of compensation for executive

management. Instead of being paid in cash, many are now compensated in stock options. If downsizing as a strategy increases equity value

(investors buy the stock of downsizers), then it increases management\'s compensation, and appears all the more attractive. This leads to the

next issue, which seriously questions an ideology which both academics and businessmen hold dear: that stock options improve firm value by

aligning the interests of owners and managers. This thesis will show that stock options are not the cure-all that many claim them to be:

3.Did the proliferation of stock options in executive compensation contribute to the wave of downsizing, especially downsizing that engendered short-term gains, but

reduced long-term firm value?

By re-aligning management\'s interests with stockholders\', the managers care more about the perceived value of the firm, not the actual value of

the firm. The stock price is based only on the perceived value-a function of the limited information which shareholders can obtain. Managers

will undertake strategies that will improve the perceived value of the firm, and to the extent that the two are correlated, as a by-product,

management may or may not improve the actual value of the firm. This raises an ambiguity about the relationship between downsizing and the

actual strength of a firm:

4.Is downsizing a signal of the strength of a firm? If so, why do firms in similar situations in a given market follow markedly different employment policies?

Lastly, downsizings may or may not be surprising to the extent that they are anticipated or accompanied by other news pertaining to

earnings or mergers. There may be a systematic under or over-reaction to a given news variable. The downsizing announcement is

relevant if it changes the expectation of the future cash flows that a stock will generate:

5. Does the stock market under or over-react to a downsizing? If so, what should an investor do following the announcement of a downsizing?

The next section will present how this paper will address each of these issues, and offer solutions, answers, and commentary.

I.2. Scope of the Downsizing Study

Utilizing theoretical, empirical, and strategic arguments, this thesis will probe the downsizing craze of the 1990s, and offer explanations to the issues

and paradoxes presented above. The thesis will consistently emphasize the importance of the information flow between the firm and its investors in

determining the stock price. The two major topics to be addressed are (1) when and why do managers utilize downsizing as a strategic technique, (2)

how do (or should) stockholders react to this news. Chapter II focuses on the history of downsizing as a fad, from its inception in the 1980s, when

only moribund firms downsized, to the mid 1990s, when all kinds of firms downsized. The macroeconomic impacts of downsizing will be addressed

by examining its impact on inflation. This has serious implications for equity values in the market as a whole.

The remainder (and bulk) of the thesis will focus on the microeconomics of downsizing: why individual firms make the choice to fire a large quantity of

their workers all at once. Chapter III offers an event study, and examines whether or not downsizing actually constitutes relevant news to the equity

value of a firm. Downsizing is shown to be a rare event in the evolution of a stock price. Using stock returns for the 38 most notorious downsizings,

news pertaining to the downsizing is proven to have no statistically significant impact on the stock return. The number of workers fired however, tends

to increase the long-run return of the stock. In general, news does not have a pronounced impact on the stock return, either due to multiple equilibria,

or to missing variables. The sign of the return on the first day is a good predictor of the medium-run return of the stock, but some over and

under-reaction may be present. Expectations of downsizing relative to the actual downsizing will be discussed as a relevant variable. The actual reaction

of the stock market to a downsizing will be measured against the efficient market hypothesis, which states that all relevant news will be immediately and

correctly incorporated into the share price. This theory will be rejected for downsizings; a systematic over-reaction to downsizings will be proven for

short holding periods of the stock.

Chapter IV examines the case of the most famous downsizing in the 1990s: the announcement that AT&T would cut a large portion of its workers.

The news came as a total surprise, as AT&T had never been stronger or more profitable. The motivation for a strong firm to downsize is discussed in

the context of a strategic game between AT&T and its investors. The game offers an explanation of why strong firms will downsize when it is clearly a

bad business strategy.

Justifications for the structure of the game are offered in Chapter V. By changing the exchange of information between managers and investors,

different equity values are obtained for the exact same payoff structures and incentives. A lack of information is proven to be beneficial to weak firms,

and reduce the equilibrium payoffs to investors and strong firms. Modifications to the payoffs that align the interests of shareholders and management

are suggested which-quite surprisingly-present stock options as reducing the equity value of the firm. Chapter VI offers extensions to the simple

game. Whether or not the game is played during a recession is also explored. Another game introduces the concept of how the potential for bankruptcy

changes the equilibrium of the simple game.

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