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Corporate Legitimacy and Investment–Cash Flow Sensitivity

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Abstract

This study provides novel evidence of the impact of corporate social responsibility (CSR) on investment sensitivity to cash flows. We posit that CSR affects investment–cash flow sensitivity (ICFS) through information asymmetry and agency costs, commonly viewed as the two channels through which investment responds to the availability of internal cash flows. We find that CSR performance leads to a decrease in ICFS. We further find that ICFS decreases (increases) when CSR strengths (concerns) increase. Finally, we find that the effect of CSR on ICFS is driven by the areas Community, Diversity, and Human Rights. In sum, the findings of this study stress the relevance of CSR—in particular, of CSR activities that extend beyond compliance behavior and reflect what is desired by society—in reducing market frictions and improving firms’ access to financial capital.

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Notes

  1. See Hubbard (1998) for a review of this literature.

  2. Kaplan and Zingales (2000), in their response to the critique of their 1997 study by Fazzari et al. (2000), stress that focusing on ICFS as a measure of financial constraint “distracts attention from the more important question: what causes this sensitivity?” (p. 711).

  3. Carroll (1979), Margolis and Walsh (2003), and Orlitzky et al. (2003) attribute the mixed evidence on the relationship between CSR and corporate performance to the omission of variables that may alter this relationship and to the different ways these concepts are defined.

  4. In an attempt to settle the debate on ICFS, Cleary et al. (2007) emphasize the importance of selecting a reliable proxy for the marginal cost of capital, which mirrors the level of market frictions that firms face.

  5. Goss and Roberts (2011) state that “A score of +2 is better than a score of +1, but we cannot infer that a score of +2 is twice as good as +1.” (p. 1798).

  6. Our results continue to hold when we include Corporate Governance in CSR_S.

  7. In our regression model we do not include CSR as a separate independent variable for two reasons. First, the correlation coefficient between \( CSR_{it} \) and \( \frac{{CF_{it} }}{{A_{it - 1} }}CSR_{it} \) is about 75%, suggesting that the two variables share a large amount of information. Second, because our focus is on the impact of CSR in reducing capital market imperfections as evident in ICFS, our objective is to get the maximum amount of information from the interaction variable \( \frac{{CF_{it} }}{{A_{it - 1} }}CSR_{it} \) (without considering the independent impact of CSR on firm investments). This model specification is commonly used in the literature on ICFS (e.g., Chen et al. 2007, p. 629; Ağca and Mozumdar 2008, p. 214; Ascioglu et al. 2008, p. 1045; Pawlina and Renneboog 2005, p. 500, among others).

  8. Goss and Roberts (2011), however, do not find a significant impact of strengths on the cost of bank debt. They also show that while banks penalize riskier (i.e., low quality) borrowers for taking on strengths, they do not penalize high quality borrowers.

  9. When we make the distinction between socially required and socially desired dimensions of CSR, we implicitly assume that, relative to socially desired areas (Community, Diversity, and Human Rights), socially required areas (Employee Relations, Environment, and Product Characteristics) are not only subject to more public pressure and monitoring, but also associated with an increased likelihood of costly sanctions.

  10. We thank an anonymous referee for suggesting these tests.

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Correspondence to Omrane Guedhami.

Appendices

Appendix A

See Table 8.

Table 8 Qualitative issue areas definitions

Appendix B

See Table 9.

Table 9 Variable definitions and data sources

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Attig, N., Cleary, S.W., El Ghoul, S. et al. Corporate Legitimacy and Investment–Cash Flow Sensitivity. J Bus Ethics 121, 297–314 (2014). https://doi.org/10.1007/s10551-013-1693-3

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