8. Effects of Corporate Social Performance on Default Risk: Structural Model-Based Analysis on Japanese Firms

Excerpt

In this chapter, we examine how firms’ corporate social performance (CSP) is related to firm default risk. We estimate the default risk of a firm by employing the structural credit risk model first developed by Merton (1974). Using the model, we explain the theoretical linkage between CSP and the probability of default (PD). We find that CSP is positively associated with the PD of financially unconstrained large-capital firms. However, PD among those large-capital firms is extremely low, and CSP exerts little influence over default risk. By contrast, among small-capital firms, CSP is negatively associated with PD. This result implies that a higher degree of CSP alleviates the default risk of small-capital firms. These asymmetric CSP effects on PD can be explained by the difference in risk and profit reduction between large- and small-capital firms. Financially constrained small-capital firms can reduce their PD and cost of debt by improving their CSP, although their corporate social responsibility (CSR) activities are detrimental to the profitability of the firm. Thus, managers of financially unconstrained small-capital firms should pay more attention to CSR activities to enhance trustworthiness in the capital market by mitigating social risk. …