Information Environment and the Cost of Equity Capital
Rodrigo S. Verdi
Massachusetts Institute of Technology (MIT)
July 7, 2005
This paper evaluates empirical proxies used to assess whether increased information risk increases the implied equity cost of capital (COC). Prior theory and empirical work offer mixed predictions and evidence on whether information risk is priced. I use principal component analysis (PCA) to aggregate previously used information risk indicators into three constructs: (1) Information Asymmetry, (2) Uncertainty, and (3) Value Relevance. Uncertainty has a significant positive relation with the COC, Asymmetry has a significant negative relation, and Value Relevance has no relation. In addition, the relation between Asymmetry and the COC is sensitive to the use of alternative COC measures. I find that indicators that ex-ante load on the same construct produce ex-post conflicting estimates on the COC. Overall, the results suggest that the choice of the proxy for information risk and the choice of COC measure can affect the inference from tests of whether increased information risk increases the COC.
Number of Pages in PDF File: 41
Keywords: Information asymmetry, information uncertainty, cost of equity capital
JEL Classification: G12, G14, D82, G30, M41
Date posted: July 19, 2005
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