Decades of marijuana prohibition in the U.S. have proven costly, consuming billions in enforcement dollars and burdening the criminal justice system with millions of marijuana-related arrests. However, as societal attitudes toward marijuana have shifted and the benefits of legalization have gained recognition, many U.S. states have decriminalized and regulated marijuana for medicinal and recreational purposes.
In light of these policy changes, an important question arises: How does marijuana legalization affect firms, particularly their financing costs? The growing acceptance and legalization of marijuana introduces new dynamics that could have far-reaching effects on the businesses operating within these evolving legal frameworks. In a forthcoming study, we explore the relationship between marijuana legalization and corporate finance, focusing on how legalization might affect firms’ cost of equity (COE).
One possibility is that it reduces a firm’s COE by alleviating labor market frictions through an expanded labor supply. For instance, prior research using an investment-based asset pricing model has shown that labor adjustment costs (e.g., difficulties in finding workers due to limited labor supply and mismatches between job seekers and available positions) can lead to higher required returns for firms. However, when these frictions are reduced (e.g., via an increasing pool of workers), firms can expand more quickly and respond more efficiently to productivity shocks. This capability allows them to earn profits more rapidly, thereby lowering the firm’s risk and, as a result, its required return or COE.
Legalizing marijuana could increase the labor supply by enabling more individuals to enter and increase their participation in the workforce, especially those previously restricted due to chronic health conditions or drug-testing policies. Furthermore, marijuana legalization could make states more attractive to out-of-state workers. Thus, to the extent that legalizing marijuana reduces labor adjustment costs via an expanded supply of workers, it can result in a lower COE for firms.
Nevertheless, marijuana legalization is not without its potential drawbacks. While it can reduce labor market frictions, significant risks could also increase financial costs for firms. Worker impairment is a major concern, particularly in safety-critical industries such as transportation and manufacturing. Employees working under the influence of marijuana could lead to lower productivity and higher safety risks, adversely affecting firm operations and increasing legal liabilities arising from accidents or injuries due to employee impairment. Additionally, broader social costs – such as substance abuse, homelessness, and public health issues – may arise from marijuana legalization, affecting firms through heightened social and worker instability.
To better understand how marijuana legalization might affect financing costs, we analyze the impact of state-level laws that legalize medical marijuana on firms’ COE using an imputation-based difference-in-differences research design over the period 1991 to 2019. Currently, 40 states and the District of Columbia have legalized medical marijuana, with 24 states and the District of Columbia also permitting recreational use. Relevant to our study, the introduction of medical marijuana legalization (MML) has had a significant impact on marijuana consumption, with studies showing an uptick following legalization.
By examining variations in MML across states, we document several key findings on how legalization affects firms’ financing costs. We show, first, that COE decreases significantly for firms in states that have legalized medical marijuana, with an average decline of approximately 34.7 to 48.4 basis points per year following MML. Given the average COE of around 8.0 percent for the firms in our sample, this reduction translates into an economically meaningful decrease of roughly 4.3 percent to 6.1 percent.
We further find that firms that are expanding, have recently experienced higher productivity, employ skilled workers, or are labor-intensive tend to see a more substantial reduction in COE. These results suggest that MML can reduce firms’ COE by decreasing labor market search frictions, particularly benefiting firms that have more to gain from lower labor-adjustment costs.
Analyzing labor-related outcomes specifically, we find that legalizing medical marijuana is associated with increases in the labor supply. Following MML, more people are likely to enter the workforce, find a job, and work more hours. Moreover, states that have legalized medical marijuana gain workers after MML, reinforcing the idea that legalization makes it easier to find and hire workers. These effects are particularly pronounced among individuals with more education, who are often in higher demand and more mobile, and among younger workers, who tend to be more willing to relocate for jobs and are disproportionately affected by stringent drug testing.
Overall, our study illustrates how changes in marijuana laws can have a significant impact on labor market dynamics, with effects that extend into capital markets. By reducing key frictions in labor markets, marijuana legalization benefits companies financially through lower equity financing costs. More generally, by examining the relationship among public health policy, labor markets, and corporate finance, our study offers policymakers and business leaders a new perspective for assessing the implications of changes to marijuana policy.
This post comes to us from professors Scott Guernsey at the University of Tennessee, Matthew Serfling at the University of Tennessee, and Cheng Yan at the Huazhong University of Science and Technology. It is based on their recent paper, “Marijuana Legalization and Firms’ Cost of Equity,” forthcoming in the Journal of Financial and Quantitative Analysis and available here.