Recently, the relation between corporate disclosure and cost of capital has received considerable attention among academics and regulators. Disclosure can refer either to mandatory or voluntary release of information about firms’ financial positions and performance. The cost of capital is the minimum return demanded by investors to invest in a new project. The cost of capital is often viewed as a metric that captures how well financial disclosure achieves its primary function of providing value-relevant information to users of financial statements. For example, the FASB states that “The benefits of financial reporting information include better investment, credit, and similar resource allocation decisions, which in turn result in more efficient functioning of the capital markets and lower costs of capital for the economy as a whole.”
In this paper, I study the effect of voluntary disclosure on cost of capital and economic efficiency, where economic efficiency is a combination of productive efficiency and efficient risk sharing. First, I isolate the firm-specific cost of capital effect caused by firms endogenous disclosure decisions from the overall cost of capital effect caused by exogenous changes in economy-wide information factors. Then, I analyze aggregate cost of capital differences across economies, and production and risk sharing efficiency caused by these economy-wide factors.
In particular, I address two questions: First, at the individual firm level, do firms that voluntarily disclose more information experience a lower cost of capital? Second, at the macroeconomic level, do endogenous firm disclosures affect aver-age cost of capital in aggregate and what are the consequences of voluntary disclosure on overall economic efficiency? Answering the first question allows us to better understand the economic forces underlying firms’ disclosures, their effects on an individual firm’s cost of capital, and the cross-sectional differences in costs of capital between disclosing and non-disclosing firms. Providing an answer to the second question could provide rule makers a useful criterion in setting disclosure policy. As noted by Sunder (2002): “cost of capital is an overall social welfare criterion rooted in equilibrium concept.”
The first of these two questions refers to the implications of disclosure on cost of capital at the individual firm level within an existing environment. Although the evidence is still relatively recent, a majority of empirical studies document a negative association between disclosure and cost of capital cross-sectionally. When disclosure itself is a choice, the interpretation of empirical results must take into account the issue of endogeneity (Skaife, Collins, and LaFond (2004), Nikolaev and Van Lent (2005), and Cohen (2008)). To capture the endogenous disclosure decision, this paper provides a model in which firms choose their disclosure to maximize their market value. In the model, firms with favorable private information are more likely to disclose. Such disclosure of favorable information reveals to the market the firm’s lower exposure to systematic risk. Responding to such a disclosure, investors rationally offer a higher price to disclosing firms, leading to a lower cost of capital.
This is the first result of the paper. This result delivers the observed cross-sectional association between disclosure and cost of capital within an economy. In other words, different firms endogenously choose different disclosures. Investors in turn rationally value firms at different prices, leading to different costs of capital. Thus disclosure and cost of capital, both endogenous in the model, appear to be negatively associated and are driven by the underlying voluntary disclosure incentive.
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A Theory of Voluntary Disclosure and Cost of Capital
