How Corporate Social Performance Influences Financial Performance: Cash Flow and Cost of Capital

While the processes linking corporate social performance (CSP) and corporate financial performance (CFP) through the satisfaction of internal and external stakeholders are well established, there is almost no literature that investigates how these processes might have an impact on the different financial mechanisms ultimately responsible for increasing firm value. In this study, the authors provide and test a unified framework to explain how corporate social performance can have an impact on corporate financial performance. They propose that CSP affects CFP by either increasing cash flows or reducing the cost of capital. They link KLD Research & Analytics, Inc., ratings of CSP with cash flow, cost of equity (market risk and firm-specific risk), cost of debt (debt ratings), and company value. The authors use fixed-effects models, random-coefficient panel regression, and portfolio models to derive their results. Using data on about 600 U.S. firms from 1995 through 2005, they show that CSP has an effect on a company’s cash flow, cost of equity, cost of debt, and value. They also find that the effect of CSP on cash flow is much more substantial than the effect on cost of capital. Further, a company’s branding strategy has an influence on the effectiveness of the CSP: the effect of CSP is stronger for companies that are visible at the level of their products (using a corporate branding strategy), than for companies that are not visible at the product level (using a house-of-brands strategy). The research shows that CSP influences both cash flow and cost of capital, which suggests that managers can use investments in CSP both to increase a company’s profitability and to reduce its cost of capital, allowing them to make a strong business case for investing in corporate social responsibility activities.