Does corporate social responsibility affect the cost of capital?
Introduction
Corporate social responsibility (CSR) has become increasingly important in recent years owing to the dramatic growth in the number of institutes, mutual funds, and online resources and other publications that specialize in encouraging corporations to improve their practices according to various responsibility criteria (Bassen et al., 2006).1 Additionally, large institutional investors such as CalPERS are showing a preference for investing in firms that pursue specific socially responsible activities (Guenster et al., forthcoming). To cope with the increased attention given to corporations’ impact on society, more than half of the Fortune 1000 companies in the US regularly issue CSR reports, and nearly 10% of US investments are screened to ensure that they meet CSR-related criteria (Galema et al., 2008). Moreover, a growing number of firms worldwide have undertaken serious efforts to integrate CSR into various aspects of their businesses (Harjoto and Jo, 2007).2
The substantial rise of CSR practices has recently fuelled research on the relationship between CSR and financial performance. To date, this line of research has produced mixed findings on the CSR effect (Jiao, 2010).3 These mixed results reflect the contrasting theoretical views on the CSR-financial performance relationship.4 Most of this prior research focuses on accounting-based or market-based measures of financial performance; few studies examine capital market participants’ perceptions of CSR.5 After reviewing a number of CSR studies, Renneboog et al. (2008) conclude that whether CSR is priced by capital markets remains an open question. They thus join previous calls for research that directly examines how CSR influences firms’ cost of equity capital (such as Kempf and Osthoff, 2007, Sharfman and Fernando, 2008). In this paper we seek to answer this call. More specifically, this paper seeks to advance our understanding of the CSR-financial performance relationship by examining whether CSR performance affects firms’ costs of equity capital.
In addition to the scarcity of empirical work on the link between CSR performance and the cost of capital, our interest in firms’ equity financing costs is motivated by the following considerations. First, the cost of equity capital is the internal rate of return (or discount rate) that the market applies to a firm’s future cash flows to determine its current market value. In other words, it is the required rate of return given the market’s perception of a firm’s riskiness. If CSR affects the perceived riskiness of a firm, as we argue below, then socially responsible firms should benefit from lower equity financing costs. Second, related research suggests that effective corporate governance, and in particular stricter disclosure standards, lowers firms’ cost of equity capital through a reduction in agency and information asymmetry problems (Botosan, 1997, Hail and Leuz, 2006, Chen et al., 2009; among others). As we argue below, information asymmetry is one of the channels through which CSR affects the cost of equity capital. Third, the cost of equity represents investors’ required rate of return on corporate investments and thus is a key input in firms’ long-term investment decisions. Examining the link between CSR and the cost of equity should therefore help managers understand the effect of CSR investment on firms’ financing costs, and hence has important implications for strategic planning. Indeed, the cost of capital could be the channel through which capital markets encourage firms to become more socially responsible (such as Heinkel et al., 2001).
Building on the theoretical frameworks of Merton, 1987, Heinkel et al., 2001, we hypothesize that ceteris paribus, high CSR firms have lower cost of equity capital than low CSR firms owing to low CSR firms being associated with a smaller investor base and higher perceived risks. To compute firms’ cost of equity capital, we follow an increasing number of studies in accounting and finance (such as Hail and Leuz, 2006, Chen et al., 2009) and use the ex ante cost of equity implied in analyst earnings forecasts and stock prices. This accounting-based approach offers two main advantages. First, unlike traditional measures of firm value (e.g., Tobin’s Q), it allows one to control for differences in growth rates and expected future cash flows when estimating firms’ cost of equity (Hail and Leuz, 2006). Second, it circumvents the use of noisy realized returns and the failure of traditional asset pricing models to deliver accurate estimates of firm-level cost of equity capital (Pástor et al., 2008).
For a sample of 12,915 US firm-year observations from 1992 to 2007, we find that firms with a better CSR score exhibit lower cost of equity capital after controlling for other firm-specific determinants as well as industry and year fixed effects. Moreover, we find that CSR investment in improving responsible employee relations, environmental policies, and product strategies substantially contributes to reducing firms’ cost of equity. We also show that firms related to two “sin” business sectors, namely, tobacco and nuclear power, appear to observe higher equity financing costs. Our evidence is robust to a battery of sensitivity tests, including alternative assumptions and model specifications, additional controls for noise in analyst forecasts and corporate governance, and various approaches to address endogeneity. Our findings support arguments in the literature that CSR enhances firm value.
Our study contributes to the literature in several ways. First, while previous studies investigate whether CSR affects firm value, this is the first study to our knowledge to use a large panel of US firms to examine the effect of CSR on the ex ante cost of equity capital. Our investigation is motivated by prior research suggesting that an important mechanism through which CSR affects firm value is its effects on firm risk (such as McGuire et al., 1988, Starks, 2009). Our empirical findings provide supportive evidence.
Second, our study complements Derwall and Verwijmeren, 2007, Goss and Roberts, 2011, Sharfman and Fernando, 2008, Chava, 2010, who also analyze the cost of capital implications of CSR. We extend Derwall and Verwijmeren (2007) by showing that overall CSR performance is associated with significantly lower cost of equity capital for a longer sample period (1992–2007 compared to 2001–2005 in their analysis) and using a wider range of implied cost of capital models. Unlike Sharfman and Fernando (2008), who rely on the CAPM to estimate the cost of equity capital, we use as an alternative the implied (ex-ante) cost of capital approach, which has been widely used in recent accounting and finance research. Additionally, while Chava, 2010, Sharfman and Fernando, 2008 focus on one particular dimension of CSR (the environment), we take a comprehensive approach that examines six dimensions related to social performance, namely, community, diversity, employee relations, the environment, human rights, and product characteristics, as well as controversial business issues. Another important difference with these studies is that we attempt to better estimate the effect of CSR by controlling for various firm-level corporate governance characteristics that have been shown to affect the cost of equity capital. Our study also extends Goss and Roberts (2011), who examine the impact of CSR on the cost of private debt. While their results based on debt financing costs imply little support for the view that CSR is priced, our evidence on equity financing costs suggests that CSR matters for equity pricing.
Third, we extend prior research that shows that firms with better corporate governance ratings enjoy lower equity financing costs (such as Chen et al., 2009). In particular, our finding that the impact of CSR continues to hold even after controlling for firm-level corporate governance suggests that firms are likely to benefit from improving not only their corporate governance, but also their social responsibility.
Finally, using a more direct proxy of expected returns, we confirm the findings of Hong and Kacperczyk (2009) that “sin” stocks generally have higher expected returns as they are less preferred by norm-constrained investors and are more likely to face greater litigation risk. Our results suggest that, among the “sin” stocks, firms related to the tobacco and nuclear power industries have a significantly higher cost of equity capital.
The remainder of the paper is organized as follows. Section 2 motivates how a firm’s CSR activities may affect its cost of equity capital. Section 3 describes our sample and discusses the regression variables. Section 4 presents the empirical evidence. Section 5 concludes the paper.
Section snippets
Corporate social responsibility and cost of equity capital
In this section, we provide theoretical arguments motivating our expectation that ceteris paribus, the cost of equity capital is lower for high CSR firms than low CSR firms. The arguments involve: (i) the relative size of a firm’s investor base, and (ii) a firm’s perceived risk.
Sample construction
To examine the relation between CSR and the cost of equity financing, we begin by merging four databases: Thompson Institutional Brokers Earnings Services (I/B/E/S), which provides analyst forecast data, Compustat North America, which provides industry affiliation and financial data, KLD STATS (created and maintained by KLD Research & Analytics, Inc. (KLD)), which provides CSR data, and CRSP monthly return files, which provide information on stock returns. We follow Gebhardt et al. (2001) and
Empirical results
As we discuss in the introduction, despite increased academic interest in CSR, we still know very little about how CSR performance affects firm valuation. The purpose of our study is to address this gap in the literature by empirically examining the link between firms’ CSR activities and their cost of equity capital. We proceed as follows. In Section 4.1 we perform univariate tests that compare the cost of equity of firms with a below-median CSR score against the cost of equity of firms with an
Conclusion
This paper examines whether corporate social responsibility affects firms’ ex ante cost of equity implied in stock prices and analysts’ earnings forecasts. We contend that ceteris paribus, high CSR firms should have lower cost of equity capital than low CSR firms owing to low CSR firms having a reduced investor base and higher perceived risk. Using a sample of 12,915 US firm-year observations from 1992 to 2007 and controlling for other firm-specific determinants as well as industry and year
Acknowledgements
We thank Najah Attig, Narjess Boubakri, Jean-Marie Gagnon, Oumar Sy, Allan Graham, Zhou Zhang, participants at the 2010 Financial Management Association Meeting, 2010 American Accounting Association Meeting, 2010 Academy of International Business Meeting, and especially an anonymous referee for their comments. We acknowledge generous financial support from Canada’s Social Sciences and Humanities Research Council and the Center for International Business Education and Research (CIBER) at the
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