Disclosure Quality, Diversification and the Cost of Capital
23 Pages Posted: 16 Nov 2013
Date Written: October 1, 2013
Based on a stylized infinite-period and multi-asset model of a securities market, I discuss several aspects of the link between disclosure quality and cost of capital, with a particular focus on how diversification influences this link. I first show that because investors have finite horizons and thus face price risk, disclosure plays a role in determining ex ante cost of capital in such a setting, contrary to the result of Christensen et al. ((2010) Information and the cost of capital: An ex ante perspective. Accounting Review 83: 817-848). With respect to diversification, I highlight the role of three aspects of a ‘large economy’ that influence how disclosure quality affects cost of capital: (1) the number of firms across which risk is distributed; (2) the number of investors among whom this risk is shared; and (3) the number of information signals (disclosures) available to investors from which to extract information. Finally, I extend the model to include the effects of nonrational traders who follow a simple trading heuristic and show that this results in an additional disclosure-contingent factor in equilibrium price that does not diversify away under fairly general conditions.
Keywords: Cost of capital, disclosure quality, diversification
JEL Classification: G10, G14
Suggested Citation: Suggested Citation