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Firms' Capital Allocation Choices, Information Quality, and the Cost of Capital

26 Pages Posted: 6 Feb 2004  

Christian Leuz

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Center for Financial Studies (CFS); University of Pennsylvania - Wharton Financial Institutions Center; CESifo Research Network

Robert E. Verrecchia

University of Pennsylvania - Accounting Department

Date Written: January 2005

Abstract

In this paper, we establish a link between information quality, firms' capital investment decisions and their cost of capital. We characterize asset prices in a market equilibrium framework with perfect competition for firm shares and derive a pricing equation that is equivalent to the CAPM. Using this characterization, we show that higher information quality leads to a lower cost of capital via its effect on expected cash flows. Better information improves the coordination between firms and investors with respect to capital investment decisions, which investors price in equilibrium by discounting firms' expected cash flows at a higher rate. This effect survives the forces of diversification in a capital market with perfect competition, even when information quality is uncorrelated across firms.

Keywords: Cost of capital, Disclosure, Information risk, Asset pricing, Risk premium

JEL Classification: G12, G14, G31, M41, M45

Suggested Citation

Leuz, Christian and Verrecchia, Robert E., Firms' Capital Allocation Choices, Information Quality, and the Cost of Capital (January 2005). Available at SSRN: https://ssrn.com/abstract=495363 or http://dx.doi.org/10.2139/ssrn.495363

Christian Leuz

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-834-1996 (Phone)

HOME PAGE: http://faculty.chicagobooth.edu/christian.leuz/

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

HOME PAGE: http://www.nber.org

European Corporate Governance Institute (ECGI)

Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Center for Financial Studies (CFS) ( email )

Gr√ľneburgplatz 1
Frankfurt am Main, 60323
Germany

University of Pennsylvania - Wharton Financial Institutions Center

3641 Locust Walk
Philadelphia, PA 19104-6218
United States

CESifo Research Network

Poschinger Str. 5
Munich, DE-81679
Germany

Robert E. Verrecchia (Contact Author)

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
215-898-6976 (Phone)
215-573-2054 (Fax)

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