Disclosure and the Option Value of Equity

40 Pages Posted: 24 Nov 2011 Last revised: 10 Dec 2013

See all articles by Eric C. So

Eric C. So

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Date Written: December 10, 2013

Abstract

This paper examines the implications of the option value of equity for firms' disclosures. Merton (1974) shows that the equity of levered firms is equivalent to a call option whose value increases in the expected variance of future cash flows. I use this equivalence to calculate firms' vega, which measures the extent to which a given firm's equity values increase from uncertainty regarding future cash flows. I hypothesize that high vega firms disclose less information because they are more likely to receive valuation benefits from increased uncertainty. Consistent with this hypothesis, I find that high vega firms provide less earnings guidance, have less readable financial statements, and are less likely to preempt earnings surprises. Additionally, I find that firms decrease earnings guidance following exogenous shocks to firms' option value of equity driven by state corporate tax rates. Taken together, the results identify the option value of equity as a channel through which firms can benefit from providing less disclosure and thus may help to explain why some firms withhold information regarding future cash flows.

JEL Classification: M00, M40, M41, G30, G31, G32

Suggested Citation

So, Eric C., Disclosure and the Option Value of Equity (December 10, 2013). Available at SSRN: https://ssrn.com/abstract=1963886 or http://dx.doi.org/10.2139/ssrn.1963886

Eric C. So (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

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