Firms' Capital Allocation Choices, Information Quality, and the Cost of Capital
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Center for Financial Studies (CFS); University of Pennsylvania - Wharton Financial Institutions Center; CESifo Research Network
Robert E. Verrecchia
University of Pennsylvania - Accounting Department
In this paper, we establish a link between information quality, firms' capital investment decisions and their cost of capital. We characterize asset prices in a market equilibrium framework with perfect competition for firm shares and derive a pricing equation that is equivalent to the CAPM. Using this characterization, we show that higher information quality leads to a lower cost of capital via its effect on expected cash flows. Better information improves the coordination between firms and investors with respect to capital investment decisions, which investors price in equilibrium by discounting firms' expected cash flows at a higher rate. This effect survives the forces of diversification in a capital market with perfect competition, even when information quality is uncorrelated across firms.
Number of Pages in PDF File: 26
Keywords: Cost of capital, Disclosure, Information risk, Asset pricing, Risk premium
JEL Classification: G12, G14, G31, M41, M45
Date posted: February 6, 2004
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