#04-08
"Firms' Capital Allocation Choices, Information Quality, and the Cost of Capital"
This paper is superseded by a working paper entitled “Accounting Information, Disclosure, and
the Cost of Capital”, with Rick Lambert and Robert Verrecchia, Working Paper #06-20.
Abstract: This paper establishes a link between firms' capital investment decisions, the quality of the information they provide to a competitive market for their shares, and their cost of capital. We show that, if firms select projects to maximize share price, higher information quality reduces the cost of capital. The intuition is that better information improves the coordination between firms and investors with respect to capital investment decisions. Anticipating this effect, risk-averse investors demand a lower risk premium, i.e., they discount expected cash flows of firms with higher quality reporting at a lower rate of return. We show that this effect persists when investors price portfolios involving many assets. Idiosyncratic reporting components matter because they affect firms' investment decisions and these real effects do not ``disappear'' when aggregating across firms.
JEL classification: G12, G14, G31, M41
Key Words: Cost of capital, Risk premium, Disclosure, Information risk, Asset pricing
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