Does the corporate social performance of a company effects its cost of equity

In recent years Corporate Social Performance is getting more and more attention from society and governments. It also is becoming getting more important a competitive factor. Focus on Corporate Social Performance (CSP) raises the question whether it pays off to invest in CSP. This thesis tries to contribute to this discussion by examining the effect of Corporate Social Performance on the Cost of Equity for U.S. companies. The relation between CSP and the Cost of Equity is based on two different theories. The Good Management (and reputation) theory states that there is a high correlation between good management practice and CSP, simply because attention to CSP areas improves relationships with key stakeholder groups, resulting in better overall performance and thus Cost of Equity. The Slack Resources Theory, on the other hand, states that better financial performance potentially results in the availability of slack (financial and other) resources that provide the opportunity for companies to invest in areas of social performance. How well a company is doing in Corporate Social Responsibility can be expressed by its Corporate Social Performance (CSP). Following prior studies, the CSP score is estimated by making use of the Kinder, Lydenberg and Domini (KLD) social ratings database. These ratings consist of 74 issues in 22 different themes. For each of these issues a binary score (0/1) is assigned, which results in a composite score when all the issues are added up to each other. The company’s Cost of Equity is estimated by the average of four models, two of which are based on the Residual Income Valuation Model and two models based on the Abnormal Earnings Growth Model. The four models are the models by Claus and Thomas (2001), Gebhardt, Lee, and Swaminathan (2001), Ohlson and Juettner-Nauroth (2005) and Easton (2004). The sample of 489 companies is examined by regressing the CSP score on the Cost of Equity estimates, while controlling for return variability, book-to-market ratio, size and type of industry. The results of the regression analysis show support for the hypothesis that companies with higher Corporate Social Performance have a significantly lower Cost of Equity. Since Corporate Social Performance has a relatively high negative correlation with the book-to-market ratio, it further can be concluded that the market values companies which invest in CSP higher than companies who invest less in CSP, which also leads to a lower Cost of Equity. In addition, large companies show a smaller Cost of Equity than small companies, but the effect is not as strong as the book-to- market ratio. Furthermore, regression results show a strong positive relation between the book-to- market ratio and the Cost of Equity, which can be the result of link between market value and Cost of Equity. The results further present a positive relation between the Cost of Equity and the size of a company. A similar relation also holds between Cost of Equity and the return variability, when higher return variability results in a lower Cost of Equity. Master Thesis Business Administration – Financial Management The results further lead to the conclusion that there are significance differences between the industries in the sample, which may be the result of a more capital intensive industry (as supported by high book-to-market ratios) or a different attitude towards innovation and CSP. Furthermore, from the result can be concluded that for companies who have high CSP the Cost of Equity decreases faster than that the increase in the Cost of Equity for companies with low CSP scores. Overall, this study provides support for managers to invest in CSP activities. These investments are not only good for society, but also lowers the Cost of Equity and therefore the financing costs of the company.