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Finance Strategic Management EssayOver the ag genius decades the concept of Corporate Social Responsibility (CSR) has continued to grow in importance and significance repayable to remote pressure of diverse stakeholders, and has thereby wrench more prominent on companies agendas (Carroll Shabana, 2010 Beurden Gossling, 2008). The concept of CSR has been caseful to considerable debate, commentary, theory building and continues research (Carroll Shabana, 2010). The question, of whether CSR investments result in fiscal and social benefits that outweigh its equals, is intensively scrutinized in existing literature (Schreck, 2001 Carroll Shabana, 2010).Adherents of CSR argue that it is in the long-term self-interest of corporations to be soci eithery involved (Carroll Shabana, 2010 Barnet 2007). The overall logic is that CSR increases the trustworthiness of firms and strengthens the relationships with stakeholders. CSR may authorise ground result in decreased transacti on costs and thereby improved corporate financial performance (CFP), by decreasing employee turnover, reducing operating costs, as well as functioning as a buffer in disruptive events (Carroll Shabana, 2010 Barnet, 2007).Barnett (2007) and Schreck (2011) argue that, if the financial benefits of CSR meet or exceed the costs, CSR can be justified as a rational investment. According to Kurucz, Colbert and Wheeler (2008), firms may attain four distinct benefits from engaging in CSR cost and lay on the line step-down gaining competitive advantage developing reputation and legitimacy and seeking winwin outcomes through synergistic care for creation. Critics of CSR typically use classical scotch arguments, articulated most forcefully by Friedman (Carroll Shabana, 2010).Traditionally, the expenditures of CSR are considered an illegitimate waste of resources, which conflict with a firms responsibility to its stockholders (Schreck, 2011, Barnet, 2007). According to Friedman (1970) There is one and only one social responsibility of business to use it resources and engage in activities designed to increase its profits so long as it corset within the rules of the game. Friedman further argued that, social issues are not the concern of business people, and the business of business is business (Carroll Shabana, 2010).Even though CSR control been subject to critique, an increasing number of corporations are accepting responsibilities that extend well beyond the immediate interest of the owners, by considering non-shareholder stakeholders concerns (Grant, 2010 Clegg, Carter, Kornberger Schweitzer, 2011). Although the existence, direction and strength of possible links among CSR and CFP have been the subject of several empirical analyses (Schreck, 2011), and even though CSR is almost universally practiced, the results from empirical studies are inconclusive (De Bakker, Groenewegen Hond, 2005).After more than thirty days of research, it cannot clearly be concluded, whether a one-dollar investment in social initiatives come downs more or less, than one dollar in benefits to shareholders (Barnet, 2007 Surroca Tribo Waddock, 2008). The inconclusiveness of empirical studies may be due to unclear and inconsistent definitions of key terms (De Bakker, Groenewegen Hond, 2005 Barnet, 2007), methodological differences (Carrol Shabana, 2010), and diverse approaches of measuring CSR and CFP (Beurden Gossling, 2008).In existing literature, CSR activities are often entioned to shrivel lay on the line, by avoiding the various consequences of incorrupt disapproval by numerous stakeholders (Zadek, 2000). However, CSR derived chance reductions are considered as an ex-post beneficial outcome and not as a proactive risk heed pecker to control or reduce single risk (firm detail). Under the assumption that, shareholders are risk adverse and prefer a high evaluate return (Bodie, Kane Marcus, 2011 B echtey, Myers Allen, 2011), a reduction of firm sp ecific risk must be perceived as favorably.Provided that CSR investments can be applied as a risk management tool, CSR could be seen as investments by firms on behalf of its shareholders. Taking a shareholder perspective, this paper looks beyond the socially good deed of CSR, and focuses on the value of CSR as a method to reduce single risk without detriment of CFP. CSR and Risk Management Since this paper hypothesizes that, CSR can be applied as a risk management tool to preserve CFP, risk need to be defined.Risk can be defined as the suspicion some outcomes or events, especially with respect to the future (Orlitzky Benjamin, 2001). Widely risk management is defined as a managerial tool to avoid risk, transfer risk to another(prenominal) party, reduce risk, or in some cases accepting consequences of a certain risk (Froot, Scharfstein Stein, 1994). A shareholders perspective on risk management however, conflicts with the capital asset pricing model (CAPM) (Markowitz, 1952) and the Modigliani Millers theorem on capital structure (1958).CAPM theory states that, the cost of reducing idiosyncratic risks simultaneously reduces the expected return, and hence firm value (Markowitz, 1952). Risk reduction by holding a well-diversified portfolio of securities will be unattainable by risk management (Godfrey, Merrill Hansen, 2009), wherefore a profit-maximizing investor would not prefer risk management. Total firm risk is in general the combination of imperious and unsystematic risk (Hoje Haejung, 2012). organized risk, often referred to as market risk or non-diversifiable risk, is usually defined as the firms sensitivity to changes in the market average returns, which cannot be reduced by diversification of shareholders (Weber, 2008 Luo Bhattacharya, 2009 Orlitzky Benjamin, 2001). Unsystematic risk is defined as idiosyncratic risk (Hoje Haejung, 2012 Luo Bhattacharya, 2009). Idiosyncratic risk is traditionally viewed as indifferent to the portfolio inves tors, since it is associated with specific companies and thereby can be reduced by diversified portfolios (Husted, 2005 Weber, 2008).Opposing idiosyncratic risk is of great relevance to the firm manager, whose very survival may depend upon taking adequate measures to reduce the idiosyncratic risk (Husted, 2005). Firms financial risk is often defined in terms of variability of returns (Orlitsky Benjamin 2001), or stock price volatility (Luo Bhattacharya, 2009), which is key risk measures, given that higher volatility implies greater investment risk and uncertain future cash flows (Luo Bhattacharya, 2009 Oikonomou, suffer Pavelin, 2012).A reduction in idiosyncratic risk reflects reduced variance in the future expected cash flows, which translates into greater shareholder wealth (Luo Bhattacharya, 2009 Mishra Modi, 2012). In a strict Modigliani and Miller perspective, risk-management instruments are of no value, since these are purely financial transactions that do not affect t he value of a telephoners operating assets (Froot, Scharfstein Stein, 1994). The views of CAMP and Modigliani and Miller have been superseded by a postmodern view of risk management as an important strategic tool.Firms do invest in insurances even though the costs of these investments may be in excess of expected losses, which is in clear violation with the perfect market assumption (Smith Stulz, 1985 Stultz, 2002). If risk management can reduce firms exposure to idiosyncratic risks, it protects shareholders against the deadweight costs of severe financial distress in a way, that investors can not accomplish in the market by diversifying (Godfrey, Merrill Hansen, 2009). Review of the linkage mingled with CSR and riskFor several decades, researchers have aimed at discovering a conclusive linkage between CSR and CFP, the literature however, remains highly fragmented (Aguinis Glavas 2012). According to Orlitsky Benjamin (2001) true frugal performance manifests itself in both hi gh financial returns and low financial risk. Among financial and non-monetary benefits, risk reduction is often mentioned as a positive outcome of engaging in CSR activities. Porter and Kramer (2006) argue that, todays pressure, of external stakeholders to hold companies accountable for social issues, learly demonstrate the potential large financial risks for any corporation.Several scholars emphasize, that the costs of CSR can be justified by reductions in risk and costs derived from assignment in social issues (Caroll Shabana, 2010). The primary argument is that the diverse demands of stakeholders represent potential threats and risks to the viability of the firm, wherefore it is the economic interest of firms to mitigate these threats and gain legitimacy through social involvement (Caroll Shabana, 2010 Schreck, 2011 Kurucz, Colbert Wheeler 2008).Existing literature on the CSR-risk relationship is virtually unanimously agreeing upon a negative correlation between CRS and idio syncratic risk, where empirical results show that CSR discredits idiosyncratic risk (Spicer, 1978 Orlitsky Benjamin, 2001 Godfrey, 2005 Hoje Haejung, 2012 Caroll Shabana, 2010 Godfrey, Merrill Hansen, 2009 Heal, 2005 Luo Bhattacharya, 2012 Oikonomou, Brooks Pavelin, 2012 Berman, Wicks, Kotha Jones, 1999 Hart, 1995 Shrivastava, 1995 Peloza, 2006).Several studies have also shown a significant negative relationship between CSR and systematic risk (non-diversifiable) (Hoje Haejung 2012 Orlitzky Benjamin, 2001 Mcguire, Sungren Scneewies, 1988 Luo Bhattacharya, 2009). CSR reduces idiosyncratic risk by reducing the probabilities of expected financial, social, or environmental crisis that could adversely influence firms cash flows (Hoje Haejung, 2012).Firms perceived as socially accountable may be able to increase interpersonal trust among stakeholders, build social capital, lower transaction costs, and therefore ultimately reduce uncertainty about future financial performance (Orlitzky Benjamin, 2001). Luo and Bhattacharya (2009) present the view of CSR, as helping the firm build a bulwark of defense against future losses of economic value by reducing firm specific risk and vulnerability of future cash flows.Firms with high social responsibility may have lower financial risk, since these are less sensitive to certain negative external events, like regulatory governmental intervention, undesirable publicity, probability of civil- and criminal legal proceedings or consumer boycotts, why risk reduction can be seen as a monetary benefit of CSR (Mcguire, Sungren Scneewies, 1988 Oikonomou, Brooks Pavelin, 2012 Weber, 2008 Orlitzky Benjamin, 2001 Mcguire, Sungren Scneewies, 1988).Participation in specific types of CSR, those aimed at a firms secondary stakeholders or society as a whole, is argued to create a form of thanksgiving or positive good-hearted moral reputational capital, which functions as an insurance-like protection, when negative events oc cur (Godfrey, 2005 Peloza, 2006). When business activity creates negative impact on society, stakeholders respond by sanctioning the firm (Godfrey, Merrill Hansen, 2009).It is argued that the goodwill, derived from affaire in CSR, reduces the overall severity of the sanctions, by encouraging stakeholders to give the firm the benefit of the doubt(Godfrey, 2005 Uzzi, 1997 Peloza, 2006 Godfrey, Merrill Hansen, 2009). The resultant moral capital gained from social engagement has detailed to do with generating financial value, but the insurance-like protection contributes with preserving shareholder value and thereby financial performance (Godfrey, Merrill Hansen, 2009).Mishra and Modi (2012) fund a significant lay out on idiosyncratic risk, when CSR is applied, the authors however enhanced this result by finding that, positive CSR reduces idiosyncratic risk, while negative CSR increases idiosyncratic risk. Literature has, according to Mishra and Modi (2012), often a risible focus on positive CSR, and overlooks that firms also occasionally engage in activities that qualifies as negative CSR. Luo and Bhattacharya (2009) and Porter and Kramer (2006) argue that CSR is not beneficial in all situations, but is rather advantageous in some contexts and disadvantageous in others and can even lead to additional risk.This is in line with Barnet (2007), who argues that stakeholders perception of firms CSR engagement are path-dependent (Barnet, 2007 Luo Bhattacharya, 2009 Hoje Haejung, 2012). For firms with social negative impact or prior bad reputation, CSR may be perceived as blood money to mitigate preceding(a) sins, omissions or shortcomings (Luo Bhattacharya, 2009 Barnet 2007). CSR can thereby lead to reduced idiosyncratic risk, but can also expose a firm to additional risk (Weber, 2008 Barnet, 2007). password Even though the CSR-risk relationship have received much concern in the existing literature, managing risk as the predominantly basic for engaging in CS R has not received specific attention. Focus within the field is on ex-post measures of risk-related benefits, where CSR is not valued as a proactive tool to reduce idiosyncratic risk. Existing research does not seem to provide any practical guidance to managerial proactive evaluations of the risk reductions derived from CSR involvement.It further lacks a practical simulation to ex-ante quantify the risk related benefits of CSR (Weber, 2008). The above review demonstrates the focus on risk, solely as valuable side-effect of engaging in CSR activities. The authors of the paper posit a research gap exists within the existing literature of CSR and risk CSR is not considered as a proactive ex-ante risk management instrument to control and reduce firm risk. Given the risk reducing benefits of CSR, the authors suggest that investments in CSR can be used as a proactive risk management instrument to reduce idiosyncratic risk.Such an approach could strengthen the overall CSR involvement and support rational ex-ante decision-making in this area (Weber, 2008). The aim is to draw a much-need attention to the risk-reduction potential of CSR by viewing CSR investments as a proactive risk management tool, where managing risk is the main purpose for engaging in CSR. Empirical resolving power the research gap and verifying the hypothesis is beyond the scope of this paper. The authors however, suggest that a potential solution is to apply real extract theory as a basis for proactive CSR risk management decision-making.CSR as a real picking Attributable to the aforementioned arguments, the function of CSR as a risk management tool can be considered as a real option. Regular options are based on securities (financial instruments), whereas real options are based on hedging against uncertainties in real investment projects (Mun, 2002). An analysis of the costs and benefits of CSR projects, using traditional NPV models, often leads to a rejection, as these fail to contribute to maximizing shareholder value (Friedman, 1962).This is, nevertheless, not always the right decision, as the NPV approach fails to incorporate the main advantage of real options (Husted, 2005). Compared to the traditional NPV approach, real options offer management flexibleness through multiple decision-making in situations with high uncertainty. Managers have the option, but not the obligation, to engage in, modifying or end strategies, as new information becomes available (Mun, 2002). A CSR option offers the choice of deferring, abandoning, expanding, or staging an investment project (Amram Howe, 2003).Due to the abstractive and mathematical complexity of option theory, which is beyond the scope of this scientific paper, option theory will be described on an incomprehensive level. In brief option pricing is a function of five variables the value of the underlie asset, the exercise price, time to exercise, the risk-free interest rate, and the volatility of the underlying asset (Bl ack Scholes, 1973).The value of the underlying asset is the resources resulted from the CSR option, such as qualified employees, PR and cost avoidings etc. Husted, 2005). The exercise price refers to the required additional investments needed for receiving the value created by the CSR option. The timing of the exercise is an essential variable, as it has great effect on the value of CSR options. The risk-free interest rate does not play an important role in most real options (Mun, 2002). The volatility or the uncertainty of the underlying asset has a significant impact on the value of CSR options (Mun, 2002). The variance of the expected value can both be higher or lower than the expected return.Black and Scholes is the most widely used regular option pricing model, however, also one of the most complicated models (Mun, 2002). A binomial lattice approach is applied in most real option pricing, as it provides a more transparent and intuitive appeal compared with Black and Scholes t heoretical and mathematical approach (Mun, 2002). However, since the aim is solely to clarify the value of real options in a CSR context, the choice of approach is of less relevance.Real options provide an important framework for firms to manage risk by reducing the risk of future investments, and can thus be an essential tool in corporate risk management (Husted, 2005). Finally, a real CSR option explicitly includes a time dimension. This ex-ante perspective is clearly different from the focus on risk in most CSR-risk research, which is ex post in nature. CSR as a risk management instrument The Toyota example A few decades ago, car manufacturers did not focus so intensively on a green profiling as they do today.The increased oil prices in 1973 and 1979 were influential for the entry of Japanese car manufacturers in USA, who were producing smaller and more botch efficient cars (Andrews, Simon, Tian Zhao, 2011). The gas efficient cars of Japanese manufactures were causative to the car industry as a whole subsequently invested massively in green technology projects. These investments have met consumers need and have generated positive branding values. Toyotas Prius has reached cult status, as it is one of the most gas efficient and green cars on the market.However, more interestingly is the security, that the green profile of the Prius has offered Toyota, which includes protection against the bad publicity of car manufacturers contribution to pollution and factors such as Middle Eastern conflicts that influence oil prices and hence sales of cars. At first glance, it appears as Toyota has been skilled at forecasting future trends and meeting clients needs without using CSR as management instrument. As the following example however illustrates, Toyotas management could have benefitted from considering investments in CSR as real options to control idiosyncratic risk and thereby preserve CFP.In 2009 repeated accidents occurred, which were accused to be caused by flaws in floor mats and accelerator pedals in Toyotas vehicles. This resulted in a deliver of more than 5 million vehicles, alone in the North American market (Andrews, Simon, Tian Zhao, 2011). Before a harvest-tide is recalled, companies have to make severe considerations. A product-recall can have great financial impact in terms of losses in brand value, consumer goodwill, decreasing sales and a negative effect on stock prices (Kumara Schmitza, 2011), which in this case is the value of the underlying asset of the CSR option.The decision to recall the cars is the price of the option. The recall option could have generated strategic flexibleness, which however, meanwhile was eliminated, as Toyotas management failed to exercise the option, before it was too late. The leisurely recall decision resulted in losses in brand value, consumer goodwill, decreased stock price, lower sales, a fine of $16 million and more than 130 potential class-action lawsuits (Andrews, Simon, Tian Zhao , 2011).The negative outcome of the late recall is considered as high volatility of the underlying asset. A faster recalling could have had a avoiding, a limited or opposite effect on product brand, consumer goodwill and the massive media coverage (Husted, 2005). Provided that Toyotas management had viewed the recall decision as a valuable option rather than severe costs, strategic flexibility could have been obtained, why the negative outcome may have been avoided.A faster exercise of the recall option might have resulted in goodwill or trust, which could have been exploited by Toyota to limit the negative publicity caused by the repeated accidents. Toyota however, failed to exercise the recall option in acute time, why the result was incapacitated flexibility to respond to the unexpected event of the accidents. The value of the real option foregone by Toyota was a function of inter alia lost sales, brand value and reputation. Toyotas management failed to exploit the advantages of CSR as a risk management tool.