The Effect of Information on Uncertainty and the Cost of Capital

52 Pages Posted: 2 Aug 2014 Last revised: 29 Jul 2015

See all articles by David Johnstone

David Johnstone

University of Sydney Business School; Financial Research Network (FIRN)

Date Written: July 20, 2014

Abstract

It is widely held that better financial reporting makes investors more confident in their predictions of future cash flows and reduces their required risk premia. The logic is that more information leads necessarily to more certainty, and hence lower subjective estimates of firm "beta" or covariance with other firms. This is misleading on both counts. Bayesian logic shows that the best available information can often leave decision makers less certain about future events. And for those cases where information indeed brings great certainty, conventional mean-variance asset pricing models imply that more certain estimates of future cash payoffs can sometimes bring a higher cost of capital. This occurs when new or better information leads to sufficiently reduced expected firm payoffs. To properly understand the effect of signal quality on the cost of capital, it is essential to think of what that information says, rather than considering merely its "precision", or how strongly it says what it says.

Keywords: Accounting information, cost of capital, CAPM, information uncertainty

JEL Classification: D8, G,10,G11, G12, G31, D81

Suggested Citation

Johnstone, David, The Effect of Information on Uncertainty and the Cost of Capital (July 20, 2014). Available at SSRN: https://ssrn.com/abstract=2474950 or http://dx.doi.org/10.2139/ssrn.2474950

David Johnstone (Contact Author)

University of Sydney Business School ( email )

Instute of Transport and Logistics Studies (C37)
The University of Sydney
Sydney, NSW 2133
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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