#06-21
Information Asymmetry, Information Precision,
and the Cost of Capital
Richard A. Lambert, Christian Leuz, and Robert E. Verrecchia, March 2006
Abstract: The consequences of information differences across investors in capital markets are still
much debated. This paper examines the relation between information differences across
investors and the cost of capital. Our analysis makes three salient points. First, in
models of perfect competition, information differences across investors affect a firm’s
cost of capital through investors’ average information precision, and not information
asymmetry per se. Second, the average information precision effect is unlikely to
diversify away when there exist many firms whose cash flows covary. Finally, in models
of imperfect competition information asymmetry affects the willingness to supply
liquidity; this, in turn, affects a firm’s cost of capital. Thus, the precision of the
information and information asymmetry have separate and distinct effects on the cost of
capital. Failure to distinguish between them jeopardizes our understanding of the link
between information and the cost of capital.
Keywords: Cost of capital, Disclosure, Information risk, Asset pricing
JEL classifications : G12, G14, G31, M41
