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When do Firms Invest in Corporate Social Responsibility? A Real Option Framework

Abstract

In this paper, the process for firms to decide whether or not to invest in corporate social responsibility is treated from a real option perspective. We extend the Husted (J Bus Ethics 60:175–183, 2005) framework with an important extra parameter that allows us to understand the timing of CSR investment and explain why some companies drag their feet over CSR investments. Our model explicitly allows for the impact of the opportunity cost of delaying the CSR investment decision, providing firms with tools to determine the optimal moment of exercising the CSR investment option. We illustrate our timing model through a case study and analyze governmental support strategies for CSR from a real options perspective.

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Notes

  1. 1.

    Consequently, as clearly established in financial option theory, holders will never execute the option before the end of the lifetime of the option.

  2. 2.

    As such we do not put this reference constantly in the body of the text to improve the readability of this section.

  3. 3.

    Potentially more, substantial deals in future would be highly uncertain.

  4. 4.

    As the sixth value driver, the interest rate r, is largely exogenous, we do not consider it further here.

  5. 5.

    In fact, this might transfer the CSR investment problem into another type of real option, i.e. a criminal option. See e.g. Engelen (2004), or Cassimon, Engelen and Reyntjens (2013) for applications.

  6. 6.

    Europe went for instance through an intensive round of renewable energy subsidies which had a huge influence on the CSR investment around renewable energy (e.g. solar panels, windmills, etc.) by private companies. With the subsidy frenzy over, we witnessed an equally remarkable drop in renewable energy investments by companies and civilians alike.

  7. 7.

    Sometimes labelled as partnering; a direct collaboration between government organizations with firms or business associations, in which public sector bodies can function as participant, convener, or facilitator (Moon et al. 2010; Fox et al. 2002).

  8. 8.

    A well-known example is The Ethical Trading Initiative (ETI). Set up in the UK mainly through government money from the Department for International Development, it brings together NGOs, companies and trade unions with the aim to improve working conditions in the apparel industry. Several companies reacted to ETI by increasing their CSR investments. It was clear from the start—due to the government commitment and the money invested—that ETI would not be reduced to a talking shop but stood a serious chance of increasing the monitoring around social conditions in the supply chain.

  9. 9.

    Fox et al. (2002) refer to it as endorsement, defined as any form of political support and affirmation of the concept of CSR and related initiatives.

  10. 10.

    This can be expressed by the following equation: \(dS = \mu \,S\,dt + \sigma \,S\,dz\), according to which a price change dS in a small time interval dt consists of two components; a deterministic component (μ), also called the drift, which measures the average growth rate of the asset price and a random or stochastic component (σ), also called the volatility, which measures the strength of the statistical price fluctuations.

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Correspondence to Danny Cassimon.

Appendix 1: The Black–Scholes Formula for Call Option Valuation

Appendix 1: The Black–Scholes Formula for Call Option Valuation

The valuation models for real options are based on the financial options’ models. The most commonly used model has been developed by Black and Scholes (1973) and Merton (1973) and is commonly referred to as the Black–Scholes model. Its popularity is derived from its closed-form solution, allowing computing the value much more simple, and in addition, the model makes it easier to conduct a sensitivity analysis using partial derivatives. The Black–Scholes analysis assumes the following (Hull 2000): (1) frictionless markets, i.e. no transaction costs or taxes, nor restrictions on short sales; (2) continuous trading is possible; (3) the risk-free (short-term) interest rate is constant over the life of the option; (4) the market is arbitrage-free; (5) the time process of the underlying asset price is stochastic and exhibits a geometric Brownian motion.Footnote 10 This process assumes asset prices to be log-normally distributed and returns to be normally distributed. Obviously, any violation of some of these assumptions may result in a different option valuation model. The goal of this article is not to provide a precise estimate of the CSR option value, but to present a richer conceptual framework that provides additional insights compared to a more conventional NPV analysis. It will be left to future research which option valuation model is the most appropriate to value CSR options, whenever a more precise estimate of the option value matters. The option value C according to the Black–Scholes model can be calculated as:

$$C = V\,e^{{ - \delta \left( {T - t} \right)}} \;N(d_{1} ) - I\;e^{{ - r_{\text{c}} \left( {T - t} \right)}} \;N(d_{2} ), \quad {\text{where}}$$
(A.1)
$$d_{1} = \frac{{\ln \left( \frac{V}{I} \right) + \left( {r_{\text{c}} - \delta + \frac{1}{2}\sigma^{2} } \right)\left( {T - t} \right)}}{{\sigma \sqrt {T - t} }}$$
(A.2)
$$d_{2} = \frac{{\ln \left( \frac{V}{I} \right) + \left( {r_{\text{c}} - \delta - \frac{1}{2}\sigma^{2} } \right)\left( {T - t} \right)}}{{\sigma \sqrt {T - t} }} = d_{1} - \sigma \sqrt {T - t} ,$$
(A.3)

where V is the present value of the future FOCFs from CSR, I is the capital expenditure (CSR investment cost), T-t is the time to expiration (in years), σ is the annualized standard deviation of the CSR project return (V), r c is the continuous risk-free interest rate, δ is the opportunity cost, and N(d) is the cumulative normal probability density function.

The effect of a change in one of the parameters on the value of the call option (the so-called Greeks), i.e. the first derivative, is calculated as follows

Sensitivity of C to Name and symbol Formula and sign of impact on C
Benefits of investment in CSR (V) Delta e δ(Tt) N(d 1) > 0
Investment cost of CSR (I) Psi Ψ − e r(Tt) N(d 2) < 0
Lifetime (T-t) Theta Θ \(\begin{gathered} \frac{{ - V\;n\left( {d_{1} } \right)\;\sigma \;e^{{ - \delta \;\left( {T - t} \right)}} }}{{2\;\sqrt {T - t} }} - r\;Ie^{{ - r\;\left( {T - t} \right)}} \;N\left( {d_{2} } \right) \hfill \\ + \delta \;V\;N\left( {d_{1} } \right)\;e^{{ - \delta \;\left( {T - t} \right)}} \hfill \\ \end{gathered}\) > 0
Risk-free interest rate (r) Rho \(\rho\) I (T-t)e r(Tt) N(d 2) > 0
Volatility (σ) Vega V \(V\;\sqrt {T - t} \;N\left( {d_{1} } \right)\;e^{{ - \delta \;\left( {T - t} \right)}}\) > 0
Opportunity cost (δ) Ksi − V(T-t)e δ(Tt) N(d 1) < 0
  1. The value N(d 1) is the derivative of the standard normal distribution function with respect to d 1

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Cassimon, D., Engelen, PJ. & Van Liedekerke, L. When do Firms Invest in Corporate Social Responsibility? A Real Option Framework. J Bus Ethics 137, 15–29 (2016). https://doi.org/10.1007/s10551-015-2539-y

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Keywords

  • Real options
  • CSR
  • Stakeholder management
  • Reputational risk
  • Optimal timing

JEL Classification

  • D81
  • G13
  • G31
  • M14
  • K42