The influence of corporate social responsibility on investment efficiency and innovation

• Author: Kirsten A. Cook,Juan Manuel Sánchez,Daniela Sánchez,Andrea M. Romi
• Date: 01 March 2019
• Published date: 01 March 2019
• DOI: http://doi.org/10.1111/jbfa.12360

DOI: 10.1111/jbfa.12360

The influence of corporate social responsibility

on investment efficiency and innovation

Kirsten A. Cook1Andrea M. Romi1Daniela Sánchez2

Juan Manuel Sánchez2

1TexasTechUniversity, USA

2Universityof Texas at San Antonio, USA

Correspondence

JuanManuel Sánchez, Department of Accounting,

OneUTSA Circle, San Antonio, TX 78249.

Email:juan.manuel.sanchez@utsa.edu

JELClassification: M41, M14, G31, O32

Abstract

We examinetwo important channels through which corporate social

responsibility (CSR) affects firm value: investment efficiency and

innovation. We find that firms with higher CSR performance invest

more efficiently: these firms are less prone to invest in negative

net present value (NPV) projects (overinvestment) and less prone

to forego positive NPV projects (underinvestment). We also find

that firms with higher CSR performance generate more patents and

patent citations. Mediation analysis indicates that firms with higher

CSR performance are more profitable and valuable, consequences

partially attributable to efficient investments and innovation. These

results, robust to alternate model specifications, lend support to

enlightened stakeholder theory.

KEYWORDS

corporate social responsibility,firm performance, innovation, invest-

ment efficiency,mediation

1INTRODUCTION

Traditional economic theory (e.g., Friedman, 1970; Jensen & Meckling, 1976) proposes that the role of managers

is to maximize shareholder wealth and that CSR activities generate agency costs, placing firms at an economic

disadvantage by benefiting other stakeholders at the expense of shareholders (Aupperle, Carroll, & Hatfield, 1985;

Cronqvist, Heyman, Nilsson, Svaleryd, & Vlachos, 2009; Kruger,2015; Pagano & Volpin, 2005; Surroca & Tribó, 2008;

Vance, 1975). In contrast, enlightened stakeholder theory (Jensen, 2001; Porter & Kramer, 2011),1predicts that

various stakeholders (e.g., shareholders, employees, customers, suppliers, the environment, the community) play

critical roles in supporting the firm's operations, and a focus on these stakeholders,through CSR activities, contributes

to shareholder value (Deng, Kang, & Low, 2013; Edmans, 2011; Guiso, Sapienza, & Zingales, 2015; Khan, Serafeim, &

Yoon, 2016; Servaes & Tamayo, 2013). We exploitthese theoretical tensions to examine the influence of CSR on two

important strategic channels by which value is generated:investment efficiency and innovation.

1Jensen(2001) refers to management's long-term focus on expanded stakeholders, in combination with profit maximization, as enlightened stakeholder the-

ory.Porter and Kramer (2011) refer to a similar strategy as shared value creation. We refer to enlightened stakeholdertheory throughout the paper to remain

consistentand attribute this terminology to the similar ideas proposed by both sets of authors.

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2018 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2019;46:494–537.

COOK ET AL.495

CSR is an important contributor to economic development (Dhaliwal, Radhakrishnan, Tsang, & Yang, 2012; Gao,

Lisic, & Zhang, 2014; Gregory, Whittaker, & Yan, 2016; McWilliams & Siegel, 2000) and reflects the commitment

by firms to behave responsibly. Hence, understanding the impact of CSR on investmentefficiency and innovation is

important because investment efficiency is critical to a firm's operations, and innovation is an important antecedent

of economic growth (Solow, 1957). We propose several reasons why CSR may enhance investment efficiency and

innovation. First, CSR increases the number of keystakeholders to whom managers are beholden, thereby augmenting

the number of monitors of managerial behavior and creating implicit contracts with an expanded set of stakeholders

(Cornell & Shapiro, 1987; Deng et al., 2013). Tothe extent the interests of the stakeholders are aligned with those of

shareholders (Freeman,1984) and monitoring is not excessive (Young,2000), such enhanced monitoring and expanded

implicit contract set should mitigate agency conflicts (Jensen & Meckling, 1976). Second, by balancing and aligning

various stakeholders’ interests and needs, managerial decision-making efficiency improves (Edmans 2011; Jensen,

2001; Porter & Kramer, 2011). Third, CSR performance improves the information environment and the quality of

accounting information (e.g., Benlemlih & Girerd-Potin,2017; Hoepner, Oikonomou, Scholtens, & Schröder, 2016; Kim,

Park, &Wier, 2012; LopezPuertas-Lamy, Dusender,& Epure, 2017; Sun, Huang, Dao, & Young, 2017), thereby reducing

information asymmetries between managers and shareholders. Collectively,higher levels of monitoring of managerial

actions and a better information environment should lead to value creation through efficient decision-making,

investment opportunities, and innovation.

Counterarguments exist for why CSR may not enhance investment efficiency and innovation. First, it is possible

that managers undertakeand disclose low-cost but highly publicized CSR initiatives, commonly referred to as “window

dressing” (Jo & Na, 2012) or “greenwashing” (Chatterji, Levine, & Toffel, 2009), that are designed to satisfy some

stakeholders’ demands for CSR without having any real impact on firm behavior and operations. Relatedly, while

a small set of firms may choose a proactive strategy and become CSR leaders, others may free-ride or implement

a reactive strategy (Eccles, Ioannou, & Serafeim, 2014; Serafeim, 2018), which should not have an impact on firm

performance. Second, considering the desires of a larger number of stakeholders may complicate or dilute the

decision-making process (particularly when various stakeholders’ interests and needs are conflicting), resulting in

suboptimal investment decisions. Third, whether CSR improvesfirms’ information environments, reduces information

asymmetries, and strengthens accounting quality depends critically on whether CSR indicators truly reflect underlying

CSR performance. Finally, extant research shows that overconfidenceleads managers to undertake inherently risky

projects (e.g., Hirshleifer,Low, & Teoh, 2012; Lawrence, Pazzaglia, & Sonpar,2011; Li & Tang, 2010; Oltra, 2008; Tang,

Li, & Yang, 2015; Oh, Chang, & Cheng, 2016), including environmental initiatives (Arena, Michelon, & Trojanowski,

2018). If managerial overconfidence influences CSR initiatives, particularly those that are superficial, we might fail to

find an association between CSR performance and investment efficiency or innovation.2

Investment efficiency relates to firms’ ability to invest optimally as a function of their implied growth, investment

opportunities, and financing capabilities. Firms that invest efficiently are less likely to overinvest[undertake projects

with negative net present values (NPVs)] or underinvest(forego projects with positive NPVs) (Biddle, Hilary, & Verdi,

2009). Following Biddle et al. (2009) and McNichols and Stubben (2008), we construct measures of investment

efficiency by modeling expected levels of total investment. Positive (negative) residual values from the prediction

model indicate overinvestment(underinvestment) relative to the expected level of investment. Our first hypothesis is

that firms with higher levels of CSR will investmore efficiently, meaning firms will be less likely to either overinvest or

underinvest.

Innovation begins with an invention, proceeds with the development of that invention,and results in the introduc-

tion of a new product, process, or service to the marketplace (Edwards & Gordon, 1984; Katila & Shane, 2005). While

the potential benefits are clear,the ability and willingness to innovate are less clear, given that the innovation process

is long, uncertain, and faces a high probability of failure (Chang, Fu., Low,& Zhang, 2015; Holmstrom, 1989; Hsu, Tian,

2Whether the arguments or the counterarguments that we outline in the preceding two paragraphsdominate and thus dictate the direction of the relation

betweenCSR and (1) investment efficiency and (2) innovation is an empirical question. As we detail in the next section of the paper, the preponderance of the

extantempirical evidence suggests positive impacts.

496 COOK ET AL.

& Xu, 2014). Further,because innovating involves substantial initial costs, firms that commit to innovation need to pos-

sess a long-term perspective (Eccles et al., 2014). Because such a focus is also necessary to implement a successful CSR

strategy (Jensen, 2001), we hypothesize that firms with higher levelsof CSR are more likely to sustain the innovation

process. Following prior research (Amore, Schneider,& Zaldokas, 2013; Chang et al., 2015; He and Tian 2013; Kogan,

Papanikolaou, Seru, & Stoffman, 2017; Nanda & Rhodes-Kropf,2013; Park, 2018), we measure unambiguous outputs

of the innovation process: the number of patents a firm holds, the number of new patents it generates, and the number

of future citations associated with those patents.

We also test the prediction that investment efficiency and innovation aretwo channels through which CSR affects

firm operating performance and value. To the extentthat CSR firms invest efficiently and have the long-term focus

required in the innovation process, we would expect higher firm performance and valuation. Using future return on

assets (ROA) and Tobin'sQ as performance measures, we carry out mediation analysis (Baron & Kenny, 1986; Hicks &

Tingley,2011) and test the prediction that the impact of CSR on firm performance and value occurs through efficient

investments and greater levelsof innovation.

Our primary analyses reveal three interrelated results. First, we find that firms with higher net CSR scores invest

more efficiently (i.e., they havelower absolute deviations from the predicted investment level). We also find that firms

with higher net CSR scores have lower levels of both overinvestmentand underinvestment. In conditional tests, after

creating a measure that captures the ex-ante likelihood of overinvestment based on a firm's cash levels and leverage,we

find that CSR constrains overinvestmentand fosters investment for those firms that have a higher likelihood of under-

investment.These results imply that firms with higher CSR scores are less prone to invest in negative NPV projects and

less prone to forego positive NPV projects. Second, regarding innovation, we find a positive relationship between net

CSR scores and (1) the number of patents the firm holds, (2) the number of new patents the firm generates, and (3) the

number of total patent citations related to patents held. Third, consistent with our third hypothesis, mediation anal-

ysis suggests that that CSR performance improves future industry-adjusted ROA and Tobin's Q, and that a significant

portion of this effect occurs through investment efficiency and innovation.These results shed light on the debate as to

whether and how CSR activities affect shareholder value (Gregory et al., 2016; Margolis, Elfenbein, & Walsh,2009; van

Beurden & Gössling, 2008).

Tomitigate the potential endogeneity issue in our setting, our main tests regress measures of future investment effi-

ciency and innovation on current measures of CSR – that is, we ensure temporalprecedence. We also include empirical

proxies of ongoing investmentpolicies and innovation programs in place in the current year, which controls for poten-

tially omitted correlated variables. Tofurther ascertain that endogeneity is not responsible for our results, we conduct

three additional sets of tests: we employ two-stage least squares estimation, where the instrumental variable (IV) is

the presence of the firm's headquarters in a “blue” state (Deng et al., 2013);3use the financial crisis as an exogenous

shock; and control for potential self-selection issues (i.e., firms choose to commit to higher CSR levels)using a Heckman

two-step approach. With one exception,inferences from these additional tests are virtually the same as those from the

main analysis.

Our research bridges three strands of research: two examining determinants of investment efficiency and inno-

vation, respectively, and one examiningthe impact of CSR on firm value. By merging these lines of research, we pro-

vide compelling evidence consistent with enlightened stakeholder theory (Jensen, 2001; Porter& Kramer, 2011). Our

results shed light on the debate regarding the value implications of CSR and suggest that, by addressing the needs and

contributions of various stakeholders, managers commit themselves to enhanced monitoring, which in turn mitigates

agency costs, contrary to CSR detractors’ arguments that CSR may be a source of agency conflicts. Our study is also

close in spirit to Deng et al. (2013), who examinethe impact of CSR on merger and acquisition (M&A) efficiency and find

that, relative to acquirers with low CSR levels, acquirers with high CSR levels realize higher stock marketreturns and

better post-acquisition long-term operating performance. By focusing on the efficiency of recurring investments and

organic growth and innovation, our study complements Deng et al. (2013), who focus on the impact of CSR on the effi-

ciency of discrete investments(M&As). By providing evidence on the impact of CSR on both over- and underinvestment

3A“blue” (“red”) state is one that politically leans Democrat (Republican). We provide more details on this in Section 5.