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Agency Costs, Leverage, and Corporate Social Responsibility: A Test of Causality

This paper focuses on different avenues of corporate social responsibility as alternative methods for alleviating agency problems between shareholders and bondholders. Specifically, the paper documents the relationship between capital structure (leverage) and corporate social responsibility. Using agency theory, a positive causal relationship is shown between leverage and certain corporate social responsibility measures and a lower cost of debt financing for firms with strong levels of corporate social responsibility. Increasing corporate involvement in current environmental and diversity issues “Granger causes” increases in firm leverage (and vice versa). However, this is not the case for other areas of corporate social responsibility including community contributions. I. Introduction A substantial body of literature addresses the agency problem inherent between corporate managers and shareholders. Two principle solutions to the problem exist: increasing effectiveness of monitoring the managers, and aligning incentives between shareholders and managers. Both solutions come at a non-trivial cost to equity holders who must balance the marginal benefits with marginal costs of each option. Similar resolutions can be made for other corporate agency problems, although little research has been done in these areas. In this paper, agency problems between bondholders and shareholders and potential alleviation of the problem through different avenues of corporate social responsibility are examined. Specifically, the relationship between capital structure (leverage) and corporate social responsibility is studied. Using agency theory, this paper documents a positive causal relationship between leverage and certain corporate social responsibility measures and a lower cost of debt financing for firms with strong levels of corporate social responsibility. Increasing corporate involvement in both environmental and diversity issues has an impact on firm leverage since the expropriation of wealth from shareholders to bondholders is reduced and incentives are more closely aligned as the goal becomes one of maximizing firm value rather than shareholder value when a discrepancy occurs between the two. However, this is not the case for other areas of corporate social responsibility including community and, to some extent, employee contributions. By studying the agency problem between bondholders and shareholders and by introducing corporate social responsibility (CSR) as a means to alleviate these problems, this paper contributes to the literature by offering a unique perspective on agency theory. In addition, it