The Effect of Asymmetric Information on the Cost of Capital

Abstract

In this paper we propose a new method to compute the cost of capital in domestic and in international settings. Our formulas show the effect of information costs on the cost of capital and give the conditions under which the domestic and the international approach yield the same results in the presence of this imperfection. Information costs are defined within the context of Merton's (1987) model of capital market equilibrium with incomplete information, CAPMI. We argue that the cost of capital in small countries should be estimated using a global CAPMI rather than a local CAPMI. Our simulation results show that the error on the cost of capital for small firms is greater than the large one.

Keywords: Cost of capital, Information costs, Local CAPM, Global CAPM

JEL Classification: G3, G15, G31, G32