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Richard Lambert* The Wharton School University of Pennsylvania Christian Leuz Graduate School of Business University of Chicago Robert E. Verrecchia The Wharton School University of Pennsylvania September 2005 Revised, August 2006

Abstract In this paper we examine whether and how accounting information about a firm manifests in its cost of capital, despite the forces of diversification. We build a model that is consistent with the CAPM and explicitly allows for multiple securities whose cash flows are correlated. We demonstrate that the quality of accounting information can influence the cost of capital, both directly and indirectly. The direct effect occurs because higher quality disclosures affect the firm’s assessed covariances with other firms’ cash flows, which is non-diversifiable. The indirect effect occurs because higher quality disclosures affect a firm’s real decisions, which likely changes the firm’s ratio of the expected future cash flows to the covariance of these cash flows with the sum of all the cash flows in the market. We show that this effect can go in either direction, but also derive conditions under which an increase in information quality leads to an unambiguous decline the cost of capital.

JEL classification: Key Words:

G12, G14, G31, M41

Cost of capital, Disclosure, Information risk, Asset pricing

*Corresponding Author. We thank Stan Baiman, John Cochrane, Gene Fame, Wayne Guay, Raffi Indjejikian, Eugene Kandel, Christian Laux, DJ Nanda, Haresh Sapra, Cathy Schrand, Phillip Stocken, seminar participants at the Journal of Accounting Research Conference, Ohio State University and the University of Pennsylvania, and an anonymous referee for their helpful comments on this paper and previous drafts of work on this topic.

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Introduction The link between accounting information and the cost of capital of firms is one of the

most fundamental issues in accounting. Standard setters frequently refer to it. For example, Arthur Levitt (1998), the former chairman of the Securities and Exchange Commission, suggests that “high quality accounting standards […] reduce capital costs.” Similarly, Neel Foster (2003), a former member of the Financial Accounting Standards Board (FASB) claims that “More information always equates to less uncertainty, and […] people pay more for certainty. In the context of financial information, the end result is that better disclosure results in a lower cost of capital.” While these claims have intuitive appeal, there is surprisingly little theoretical work on the hypothesized link. In particular, it is unclear to what extent accounting information or firm disclosures reduce non-diversifiable risks in economies with multiple securities. Asset pricing models, such as the Capital Asset Pricing Model (CAPM), and portfolio theory emphasize the importance of distinguishing between risks that are diversifiable and those that are not. Thus, the challenge for accounting researchers is to demonstrate whether and how firms’ accounting information manifests in their cost of capital, despite the forces of diversification. This paper examines both of these questions. We define the cost of capital as the expected return on a firm’s stock. This definition is consistent with standard asset pricing models in finance (e.g., Fama and Miller, 1972, p. 303), as well as numerous studies in accounting that use discounted cash flow or abnormal earnings models to infer firms’ cost of capital (e.g., Botosan, 1997; Gebhardt et al., 2001).1 In our model, we explicitly allow for multiple firms whose cash flows are correlated. In contrast, most analytical models in

We also discuss the impact of information on price, as the latter is sometimes used as a measure of cost of capital. See, e.g., Easley and O’Hara (2004) and Hughes et al. (2005).

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accounting examine the role of information in single-firm settings (see Verrecchia, 2001, for a survey). While this literature yields many useful insights, its applicability to cost of capital issues is limited. In single-firm settings, firm-specific variance is priced because there are no alternative securities that would allow investors to diversify idiosyncratic risks. We begin with a model of a multi-security economy that is consistent with the CAPM. We then recast the CAPM, which is expressed in terms of returns, into a more easily interpreted formulation that is expressed in terms of the expected values and covariances of future cash flows. We show that the ratio of the expected future cash flow to the covariance of the firm’s cash flow with the sum of all cash flows in the market is a key determinant of the cost of capital. Next, we add an information structure that allows us to study the effects of accounting information. We characterize firms’ accounting reports as noisy information about future cash flows, which comports well with actual reporting behavior. We demonstrate that accounting information influences a firm’s cost of capital in two ways: 1) direct effects – where higher quality accounting information does not affect cash flows per se, but affects the market participants’ assessments of the distribution of future cash flows; and 2) indirect effects – where higher quality accounting information affects a firm’s real decisions, which, in turn, influences its expected value and covariances of firm cash flows. In the first category, we show (not surprisingly) that higher quality information reduces the assessed variance of a firm’s cash flows. Analogous to the spirit of the CAPM, however, we show this effect is diversifiable in a “large economy.” We discuss what the concept of “diversification” means, and show that an economically sensible definition requires more than simply examining what happens when the number of securities in the economy becomes large.

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Moreover, we demonstrate that an increase in the quality of a firm’s disclosure about its own future cash flows has a direct effect on the assessed covariances with other firms’ cash flows. This result builds on and extends the work on “estimation risk” in finance.2 In this literature, information typically arises from a historical time-series of return observations. In particular, Barry and Brown (1985) and Coles et al. (1995) compare two information environments: in one environment the same amount of information (e.g., the same number of historical time-series observations) is available for all firms in the economy, whereas in the other information environment there are more observations for one group of firms than another. They find that the betas of the “high information” securities are lower than they would be in the equal information case. They cannot unambiguously sign, however, the difference in betas for the “low information” securities in the unequal- versus equal-information environments. Moreover, these studies do not address the question of how an individual firm’s disclosures can influence its cost of capital within an unequal information environment. Rather than restricting attention to information as historical observations of returns, our paper uses a more conventional information-economics approach in which information is modeled as a noisy signal of the realization of cash flows in the future. With this approach, we allow for more general changes in the information environment, and we are able to prove much stronger results. In particular, we show that higher quality accounting information and financial disclosures affect the assessed covariances with other firms, and this effect unambiguously moves a firm’s cost of capital closer to the risk-free rate. Moreover, this effect is not diversifiable because it is present for each of the firm’s covariance terms and hence does not disappear in “large economies.”

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See Brown (1979), Barry and Brown (1984 and 1985), Coles and Loewenstein (1988), and Coles et al. (1995).

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Next, we discuss the effects of disclosure regulation on the cost of capital of firms. Based on our framework, increasing the quality of mandated disclosures should in general move the cost of capital closer to the risk-free rate for all firms in the economy. In addition to the effect of an individual firm’s disclosures, there is an externality from the disclosures of other firms, which may provide a rationale for disclosure regulation. We also argue that the magnitude of the cost-of-capital effect of mandated disclosure will be unequal across firms. In particular, the reduction in the assessed covariances between firms and the market does not result in a decrease in the beta coefficient of each firm. After all, regardless of information quality in the economy, the average beta across firms has to be 1.0. Therefore, even though firms’ cost of capital (and the aggregate risk premium) will decline with improved mandated disclosure, their beta coefficients need not. In the “indirect effect” category, we show that the quality of accounting information influences a firm’s cost of capital through its effect on a firm’s real decisions. First, we demonstrate that if better information reduces the amount of firm cash flow that managers appropriate for themselves, the improvements in disclosure not only increase firm price, but in general also reduce a firm’s cost of capital. Second, we allow information quality to change a firm’s real decisions, e.g., with respect to production or investment. In this case, information quality changes decisions, which changes the ratio of expected cash flow to non-diversifiable covariance risk and hence influences a firm’s cost of capital. We derive conditions under which an increase in information quality results in an unambiguous decrease in a firm’s cost of capital. Our paper makes several contributions. First, we extend and generalize prior work on estimation risk. We show that information quality directly influences a firm’s cost of capital and that improvements in information quality by individual firms unambiguously affect their non-

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Beaver et al. 2005. In this case. 2004. In this sense. 2005. Hail and Leuz. and their cost of capital (e. 2006). e. our study provides theoretical guidance to empirical studies that examine the link between firms’ disclosures and/or information quality.g. our model does not provide support for an additional risk factor capturing “information risk... provide a careful justification for the inclusion of information variables. that the information effects of a firm’s disclosures on its cost of capital are fully captured by an appropriately specified. however.g. across countries (e. without reference to market liquidity. may not capture all information effects. (2006) for an empirical analysis that relates accounting information to a firm’s beta. at least. forward-looking beta.”3 One way to justify the inclusion of additional information variables in a cost of capital model would be to note that empirical proxies for beta. in the empirical specification. our study provides an explanation for studies that find that international differences in disclosure regulation explain differences in the equity risk premium. This finding is important as it suggests that a firm’s beta factor is a function of its information quality and disclosures. and their functional form. however. Thus.. and Core et al.diversifiable risks. or the average cost of equity capital. Ashbaugh-Skaife et al. Based on our results. the most natural way to empirically analyze the link between information quality and the cost of capital is via the beta factor. it is incumbent on researchers to specify a “measurement error” model or.g. Prior work suggests an indirect link between disclosure and firms’ cost of capital based on market liquidity and adverse Note that our model also does not preclude the existence of an additional risk factor in an extended or different model. Botosan.... Botosan and Plumlee. Francis et al. Berger et al. (1970) and Core et al.4 A second contribution of our paper is that it provides a direct link between information quality and the cost of capital. In addition. This issue is left for future research. 2005). It is important to recognize. 4 See. 2002. however. which for instance are based on historical data alone. 1997. 3 5 ..

2001. it is unclear whether the effects demonstrated in these studies survive the forces of diversification and extend to more general multi-security settings. 1996. We emphasize. which in turn manifest in firms’ cost of capital. Our paper focuses on an alternative. and derives the determinants of the cost of capital. to the cash flow at the end of the period..g. that equates the stock price at the beginning of the period. defines terms. that we do not dispute the possible role of market liquidity for firms’ cost of capital. Pj. our paper contributes to the literature by showing that information quality has indirect effects on real decisions.g. Model and Cost of Capital Derivation We define cost of capital to be the expected return on the firm’s stock. Sections 3 and 4 analyze the direct and indirect effects of accounting information on firms’ cost of capital. as several empirical studies suggest (e. Kanodia et al. do not analyze the effects on firms’ cost of capital or nondiversifiable risks. In this sense. Pastor and Stambaugh. Baiman and Verrecchia. however. Easley et al. Amihud and Mendelson. the expected rate of return on a firm j’s stock is the rate. our study relates to work on real effects of accounting information (e. 6 . Rj. 2000 and 2004). 2. Finally. analyze settings with a single firm (or settings where cash flows across firms are uncorrelated)..g. and possibly more direct. Easley and O’Hara. Chordia et al. Thus. respectively. Diamond and Verrecchia. These studies. Consistent with standard models of asset pricing. explanation as to how information quality influences non-diversifiable risks. 1991. The remainder of this paper is organized as follows.. These studies. however. 2004)... 2002.selection in secondary markets (e. 2003).. Section 5 summarizes our findings and concludes the paper. Section 2 sets up the basic model in a world of homogeneous beliefs. however. 1986.

Because the CAPM is expressed solely in terms of covariances. or. the covariance of its future return with that of the market portfolio. Our analysis focuses on the expected rate of return. the expected return on ~ the market. and is based on the information available to market participants. Lintner. the CAPM expresses the expected return on a firm’s stock as a function of the risk-free rate. alternatively. ~ Var ( R M | Φ ) [ ] [ ] (1) Eqn. We assume there are J securities in the economy whose returns are correlated. Assuming that returns are normally distributed or. this formulation might be interpreted as implying that other factors. E ( Rm ). for example the expected cash flows. we assume market participants possess homogeneous beliefs regarding the expected end-of-period cash flows and covariances. which Vj: P j (1 + Rj) = V j . more specifically. that investors have quadratic utility functions. do not affect the 7 . 1964. or R j = Pj ~ E (V j | Φ ) − Pj ~ . R m | Φ ) . and the firm’s beta coefficient. Consistent with the conventional formulation of the CAPM. This covariance is a forward-looking parameter. Rf. 1965). (1) shows that the only firm-specific parameter that affects the firm’s cost of capital is its beta coefficient. The best known model of asset pricing in such a setting is the Capital Asset Pricing Model (CAPM) (Sharpe. and then transform this formulation and add an information structure to show how information quality affects expected returns. Therefore. we begin our analysis by presenting the conventional formulation of the CAPM.~ V j − Pj ~ ~ ~ . βj: ~ E (R M | Φ ) − R f ~ ~ ~ ~ E(R j | Φ ) = R f + E(R M | Φ) − R f β j = R f + Cov ( R j . where Φ is the information available to market participants to is E ( R j | Φ ) = Pj make their assessments regarding the distribution of future cash flows.

If we make more specific assumptions regarding investors’ preferences. . (2) indicates that the current price of a firm can be expressed as the expected end-of-period cash flow minus a reduction for risk. we can 8 . however. Clearly the current stock price is a function of the expected-end-of-period cash flow. In particular. [83]): ~ E (VM | Φ ) − (1 + R f ) PM ~ E (V j | Φ ) − ~ Var (VM | Φ ) Pj = (1 + R f ) ⎡ ⎤ ~ J ~ Cov ( V j . j = 1. that the covariance term in the CAPM is expressed in terms of returns. eqn. and an individual firm component. (2) ~ E (VM | Φ ) − (1 + R f ) PM has both a macro-economic factor. k =1 Eqns. The risk reduction factor in the numerator of eqn. or through the current period stock price. ∑ Vk | Φ ) ⎥ ⎢ k =1 ⎦ ⎣ J ~ ~ of firm j to the overall variance of the market cash flows. (1) and (2) express expected returns and pricing on a relative basis: that is. J. …. This expression implies that Pj PM information can affect the expected return on a firm’s stock through its effect on inferences about the covariances of future cash flows. (2) Eqn. As in Fama (1976).firm’s cost of capital. the CAPM can be re-expressed in terms of prices instead of returns as follows (see Fama . the term ⎡Cov(V j . relative to the market. ∑ Vk | Φ ) ⎥ ⎢ k =1 ⎣ ⎦. not in terms of cash flows.VM ) . ⎢ ⎣ Pj PM ⎥ ⎦ ~ ~ 1 ~ ~ Cov(V j . This risk-adjusted expected value is then discounted to the beginning of the period at the risk-free rate. The two are related via the ⎡ V j VM ⎤ ~ ~ equation Cov ( R )⎥ = j . VM = ∑ Vk . It is important to keep in mind. or both.1976. ~ Var (VM | Φ ) which is determined by the covariance of the firm’s end-of-period cash flows with those of all ~ J ~ ⎤ is a measure of the contribution other firms. RM ) = ⎢Cov ( .

price in eqn. (3) to express the expected return on the firm’s stock as follows. ∑ Vk | Φ)⎥ E (V j | Φ) − Nτ ⎢ ⎥ k =1 ⎣ ⎦ Pj = 1+ Rf . (3) is equal to the expected end-of-period cash flow minus a reduction for the riskiness of firm j. if the economy consists of N investors with negative exponential utility with risk tolerance parameter τ and the end-of-period cash flows are multi-variate normally distributed. We can re-arrange eqn. (2). 9 . ∑ Vk | Φ )⎥ E (V j | Φ ) − Nτ ⎢ ⎥ k =1 ⎣ ⎦ (4a) 5 More specifically. Cov V R E V j ∑ Vk | Φ )⎥ f j ~ Nτ ⎢ ⎥ E (V j | Φ ) − P j ~ k =1 ⎣ ⎦.express prices and returns on an absolute basis. (3) across all 1 ~ ~ firms: (1 + R f ) PM = E (VM | Φ ) − Var (VM | Φ ) . The cost of capital for firm j is J ⎤ 1 ⎡ ~ ~ ~ ⎢ Φ + ( | ) ( . which is the aggregate risk tolerance of the marketplace. then the beginning-of-period stock price can be expressed as (details in the Appendix): J ⎤ 1 ⎡ ~ ~ ~ ⎢Cov(V j . which acts as the numeraire in the economy. all discounted back to the beginning of the period at the riskfree rate. which can also be expressed as Nτ ~ E (VM | Φ ) − (1 + R f ) PM 1 = . the aggregate risk tolerance of the market determines ~ Nτ Var (VM | Φ ) the risk premium for market-wide risk. the pricing and return formulas will be expressed relative to the risk-free rate. Therefore. = E ( R j | Φ) = J Pj ⎤ 1 ⎡ ~ ~ ~ ⎢Cov (V j . (3) As in eqn. The price of the market portfolio can be found by summing eqn. The discount for risk is now simply the contribution of firm j’s cash flows to the aggregate risk of the market divided by the term Nτ.5 In particular. Lemma 1.

and k =1 ~ J ~ ~ (d) increasing (decreasing) in Cov(V j . ∑ Vk | Φ ) ≠ 0. where E ( R j | Φ) = H (Φ ) − 1 H (Φ ) = ~ E (V j | Φ ) 1 ~ Cov (V j . (b) decreasing (increasing) in the aggregate risk tolerance of the market. Nτ . when the expected cash flow and covariance of that cash flow with the market have the same (different) sign. ~ (4b) k =1 ∑ Vk | Φ) J Lemma 1 shows that the cost of capital of the firm depends on four factors: the risk free rate. ∑ Vk ) is positive (negative). or the covariance of that cash flow with the market. when the expected cash flow and the price of the firm have the same (different) sign. be of any particular sign. ~ (c) decreasing (increasing) in the expected end-of-period cash flow. ~ Proposition 1. Rf . when ~ J ~ Cov(V j . the covariance between its end-of-period cash 10 . this reduces to k =1 ~ J ~ R f H (Φ ) + 1 ~ . k =1 To make the intuition that underlies Proposition 1 as transparent as possible. and the covariance of the firm’s cash flow with the sum of all the firms’ cash flows in the market. is: (a) increasing (decreasing) in the risk free rate. Note that the definition of cost of capital in Lemma 1 does not require that firm j’s expected cash flow. E ( R j | Φ ). the aggregate risk tolerance of the market. to firm j’s contribution to aggregate risk per-unit-of aggregate risk tolerance. Ceteris paribus the cost of capital for firm j. Nτ.If we further assume that Cov(Vj . ∑ Vk ) when E ( V j ) is positive (negative). the expected cash flow of the firm. E ( V j ) . In the next result we show how a change in each of the four factors affects cost of capital. The latter three terms can be combined into the ratio of the firm j’s expected cash flows. consider the case in which firm j’s expected end-of-period cash flow.

the expected return must increase to compensate investors for the increase in risk. It only requires that cash flows are multivariate normally distributed. Clearly the cost of capital for the firm will be somewhere in between the cost of capital j for the riskless component and the cost of capital for the risky component. 1965). or negative exponential. To see this. utility function. that this result is robust. Here. and the firm’s beginning-of-period stock price are all positive. To illustrate. the aggregate risk tolerance of the market increases. however. because this provides the baseline return for all securities. however. 11 . One potential concern may be that the effect of the expected cash flow on the expected return is specific to the CARA. the reason why the expected return on firm j is increasing in the risk-free rate is clear.6 This moves ~ J ~ the firm’s expected rate of return closer to the risk-free rate. But if the firm’s expected cash flow increases without affecting the firm’s variances or covariances. When Cov(V j . we can start with our equation (2): 6 This is analogous to the effect discussed in Merton (1987). This is one of the key insights of the CAPM (Sharpe.flow and the market. The intuition. We believe. 1964. ∑ Vk ) increases. hence. is fairly straightforward. the discount applied to each firm’s riskiness decreases. When Nτ increases. k =1 the contribution of the riskiness of firm j’s cash flows to the overall riskiness of the market goes up. note that the traditional CAPM formulation of pricing does not assume negative exponential utilities. Consider a firm with two components of cash flow: a riskless component ( V a ) and a risky component j ( V b ). Lintner. The firm’s cost of capital therefore decreases. hence. Perhaps the most surprising result is that an increase in the expected value of cash flows decreases the expected rate of return. this is exactly analogous to adding a new riskless component of cash flows to the firm’s existing cash flows.

holding the others constant. and thus cancel out. On the contrary.. that the result will hold in far more general terms. the expected return is decreasing in E(Vj). J λCov(V j . E (V j ) . ceteris paribus. the comparative statics in Proposition 1 go through. In this special case. where is a market-wide Pj = ~ Var(VM | Φ) (1 + R f ) parameter. however. In particular. While it is common in some corporate finance and valuation models to assume that the level of cash flow and the covariances move in exact proportion to each other (i.e. it is easy to see that the numerator and denominator each change by that proportion in eqn. (4).J % | Φ ) − λ ⎡Cov(V % . however. λ. we are unaware of any theoretical results or empirical evidence to suggest this should be the case. ∑Vk ) j =1 Assuming the impact of a single firm is small relative to the market as a whole. ∑V % | Φ)⎤ ~ E (V j j k ⎢ ⎥ E(VM | Φ ) − (1 + R f )PM k =1 ⎣ ⎦ λ = . such that the market-wide term. which is why we add structure by assuming the negative exponential utility. all cash flows are from the same risk class). It seems clear. where now H = H + 1. Obviously. There is an effect. the existence of fixed costs in the production 12 . The results in Proposition 1 vary one parameter at a time. is unaffected. for any simultaneous change that is not exactly proportionate on the two terms. Using the same steps as the derivation in Proposition 1. we can write the expected return on firm j's stock as: E(R j ) = E (V j ) − P j Pj = HR f − 1 . there is no effect on the cost of capital. the assumption that the market-wide term is unaffected is “less clean” than our prior derivation. But what if the expected cash flows and the covariance change simultaneously? For the special case where expected cash flows and the covariance both change in exactly the same proportion.

the expected return changes. generally make the expected values and covariances of firm’s cash flows change in ways that are not exactly proportional to each other. etc. In the following two sections we focus on how accounting information impacts the H(Φ) ratio in the cost of capital equation. and (b) the change (if any) in the distribution of cash flows due to the investment policy. Our model is one-period model.e. 7 13 . – that affects the H term has a corresponding effect on the firm’s expected return. and how this assessment impacts the firm’s cost of capital. there is ample empirical evidence that betas vary over time. One scenario where the overall effect might be zero is the one where the new cash flows are re-invested in exactly the same risk-return profile as the firm's other projects. economies of scale. these cash flows could be re-invested in the firm.function. etc. This latter effect is analogous to our “real effects” analysis in Section 4.. Moreover.. If the end result of an increase in expected cash flows combined with a re-investment policy results in a change in the parameter H. ratio of the expected cash flows to the covariance with all other firms. and that this naturally leads to changes in the risk-return characteristics of the firm. More generally. then the effects do not exactly offset each other. as suggested by the literature on the free-cash flow problem. which implies the ratio of expected cash flow to overall covariance varies. inventions. taxes.7 There is nothing in Proposition 1 that is specific to accounting information. In section 3. we show how. Any shock – new regulations. Our model applies to any re-investment policy. holding the real decisions of the firm fixed. in a multiperiod model. thereby affecting the firm’s cost of capital. Our analysis does not make any assumptions about the nature of the re-investment policy. suggesting that new information has an impact as it becomes available. we show that accounting information affects real actions within the firm. accounting information affects the assessments made by market participants of the distribution of future cash flows. For any other investment policy. the cost of capital will change. if managers have an incentive to “hoard” excess cash. Our analysis also provides sufficient conditions where these two effects do not offset (see Proposition 4). i. In section 4. The re-investment policy will depend on the nature of the investment opportunity set and the manager’s incentives. which implies that the end-of-period cash flows are consumed by shareholders. For example. and the overall effect on the firm's cost of capital can be thought of as the sum of two (potentially offsetting) effects: (a) the effect of the cash flow shock per se.

As an application. let V0j and ω j represent the ex-ante expected value and ex-ante precision of the end-of-period cash flow. zj1. consider the impact on the cost of capital of firm j if more information becomes available (either through more transparent accounting rules. V j ) + Cov(V j . about the ultimate realization of firm j’s cash 14 . additional firm disclosure. In the next two sub-sections.3. ∑ Vk ) = Cov(V j . respectively. To do so... decreasing and increasing functions of the covariance of a firm’s end-of-period cash flow with the sum of all firms’ end-of period cash flows. we discuss the two components of this covariance: the firm’s own variance and the covariances with other firms. ∑ Vk ). investing.zjQ.1 Direct Effects – Through the Variance of the Firm’s Cash Flow The idea that better quality accounting information reduces the assessed variance of the firm’s cash flow is well known. we add a general information structure to the model. respectively. and financing) decisions constant (we relax this in Section 4). eqns. Even though accounting and disclosure policies do not affect the real cash flows of the firm here. As a result. which allows us to analyze the direct effects of information quality on the cost of capital. (3) and (4) show that stock price and the expected return are. Direct Effects of Information on the Cost of Capital In this section. ~ J ~ ~ ~ ~ ~ Cov(V j . k =1 k≠ j 3. Suppose investors receive Q independently distributed observations. they affect equilibrium stock prices and expected returns. or greater information search by investors).. In particular. they change the assessments that market participants have regarding the distribution of these future cash flows.. we hold the firm’s real (operating. Suppose the firm’s investment decisions have been made.

γj. For example. Moreover.flow. and precision ω j + Qγ j . z jQ ) = ωj ω j + Qγ j V0 j + γj ω j + Qγ j q =1 ∑ z jq . reducing the assessed variance of the firm’s cash flows increases the firm’s stock price and reduces the firm’s expected return. their assumption that all cash flows are independently distributed implies that the pricing of each firm 15 .. In particular.. The firm-specific variance reduction effect is an important factor in the cost of capital analysis of Easley and O’Hara (2004). 2) the number of new observations. ceteris paribus. where each observation has precision γ j . a decrease of. While their paper models a multi-security economy. Then investors’ posterior distribution for endof-period cash flow has a normal distribution with mean ~ E (V j | z j1. there is a non-zero effect on price and on the cost of capital of reducing the assessment of firmvariance. say. because the variance term is an additively separate term in the overall covariance. for a given finite value of N (the number of investors) and J (the number of firms in the economy). Since the assessed variance of the firm’s cash flow is one of the components of the covariance of the firm’s cash flow with those of all firms. or 3) the precision of these observations.. Therefore. the assessed precision increases) with 1) an increase in the prior precision. 10 percent in the assessed variance of firm cash flows has the same dollar effect on stock price regardless of the degree of covariance with other cash flows.. the magnitude of this impact on price does not depend on how highly the firm’s cash flows co-vary with those of other firms. then using part (d) of Proposition 1. Q The analysis above formalizes the notion that accounting information and disclosure reduce the assessed variance of the firm’s end-of-period cash flows. Q. ωj. the assessed variance decreases (equivalently.

their pricing equation reduces to (their analysis assumes the risk-free rate is zero): x 1 ~ .0 in our analysis). Since the assessed precision of cash flows. Instead. regardless of its interpretation. the impact of information on the equilibrium price is similar to our eqn. consider as one polar case a situation in which the number of firms in the economy increases. while holding the number of investors fixed. Moreover. In particular. by construction. This implies that J (the number of securities) and N (the number of investors) must both get large. the fact that their “information effect” takes place in firms’ variances implies that. The individual variances of the firms’ returns asymptotically disappear. R k ). As J gets large this converges to the average covariance Variance ( ∑ R j ) = AverageVar ( R j ) + J J J j 8 between the returns in the portfolio. To see this. and the discount of price relative to the expected cash flow declines. if we simplify their model to remove the private information component of their model.8 Next we address the question of the diversifiability (or magnitude) of the effect of reducing the market’s assessed variance of the firm’s cash flows. the effect is diversifiable and hence vanishes as the economy gets large. and economy-wide risks are priced. 16 . it is the average precision of investors’ information that determines the cost of capital in Easley and O’Hara (2004). the variance of an equally weighted portfolio of J securities can be expressed as J −1 1 1 ~ ~ ~ ~ AverageCov ( R j . we must ensure that economy-wide risks are absorbed by the market participants collectively. the assessed variance of the firm’s cash flows goes down. This does make the contribution of firm variance small relative to the covariance with all firms In a model with heterogeneous information across investors. As more public information is generated. and all covariances are. Intuitively. Pj = E (V j ) − Nτ ω j + Qγ j (5) where x is the supply of the risky asset (this is 1. the notion that a risk is diversifiable is usually expressed in terms of how it affects the variance of a portfolio as the number of firms in the portfolio gets large.9 To examine this more rigorously. ωj + Qγj .is also done independently. 9 In particular. (2006) show that the cost of capital effect in Easley and O’Hara (2004) is not driven by the asymmetry of information across investors per se. equal to zero. (3). Lambert et al. is the inverse of the assessed variance of cash flows.

asymptotically approaches zero. Our work in this section builds on the estimation risk In our simplified version of the Easley and O’Hara result (our eqn. which reduces all risk premiums and decreases all expected returns. alone grows large. however. 1 ~ ~ Cov (V j . To avoid these uninteresting. in their “full blown” model (see their proposition (2). the aggregate risk J ~ ~ in the economy: that is. [5]).(assuming firms’ covariances tend to be positive).Vk ) increases without bound. When J and N both increase. no risks are priced. In the limit. Nτ k ≠ j survives because the number of covariance terms (J-1) also increases as the economy gets large. consider as the other polar case a situation where N. because this term only appears once in the Nτ overall covariance for a firm. the effect of firm-variance on the cost of capital. therefore. Similarly. Therefore. the number of investors in the economy. the firm is priced as if it is riskless (recall that Easley and O’Hara assume there are no covariances with other firms). we show that information about a firm’s future cash flows also affects the assessed covariance with other firms.10 The covariance with other firms. [3] and [4]). as N gets large the per-capita supply of the firm’s stock goes to zero. 1 J ~ ~ ∑ Cov (V j . In the next section. 3.2 Direct Effect – Through the Covariance with other Firms’ Cash Flows In this section. This drives prices lower and k =1 results in an infinite increase in the expected return required to hold the stock (see eqns.V j ). ∑ Cov(V j . polar cases. J and N must both increase for the notion of “diversifiability” to be meaningful. 10 17 . and again the pricing equation collapses to a risk-neutral one. This will result in spreading all risks (not just firms’ variances) over more investors. 1 ~ ~ ∑ Cov (V j . the last term on the righthand side of the equation approaches zero. On the other hand. however. It also increases. we analyze how information affects the covariance terms.Vk ). as N gets large.Vk ) approaches zero for each firm and even for the N k =1 market.

This is one reason why they obtain results that are mixed or difficult to sign. 1995). our work differs from this literature in three important ways.1988. unlike the prior literature. our model represents information differently than in the estimation risk literature. Other papers compare two information environments: an environment where the amount of information is equal across all firms to an environment where investors have more information for one subgroup of firms than they do for a second group. While this literature claims that the intuition behind their results applies to information more generally. whereas our focus is on the cost of capital. Second. and Coles et al. The estimation risk literature assumes the information about firms arises from historical timeseries observations of firms’ returns.1979.. the estimation literature focuses on very specific changes in the information environment. we are able to address the question of how more information about one firm affects its cost of capital within an unequal information environment. the impact on beta is confounded by the simultaneous impact on the covariances between firms and the variance of the market portfolio. we can analyze the impact of both effects. Specifically. the estimation risk literature generally focuses on the impact of the information environment on the (return) beta of the firm. Barry and Brown. Coles and Loewenstein. Finally. Because the information structures analyzed in this literature generally affect all firms in the economy. In particular. Some papers examine the impact of increasing equally the amount of information for all firms. the assumed time-series nature of their characterization of information drives a substantial element of the covariance structure in their 18 . By focusing on the cost of capital.1984 and 1985. First.literature in finance (See Brown. Our framework allows us to analyze more general changes in information structures: both mandatory and voluntary.

Z j could also be informative about the cash flow of other firms. new information is correlated conditionally with contemporaneous observations and conditionally independent of all other information. Hughes et al. Our characterization of disclosures as noisy information about firms’ future cash flows (or other performance measures) also comports well with actual disclosure practices. 11 12 See Kalymon (1971) for the original derivation of the covariance matrix used in much of this literature. is modeled as Z j = V j + ε j . about ~ ~ ~ ~ ~ ~ firm j’s cash flow. assumes a very specific “factor” structure. not just of the idiosyncratic component of future earnings. in our model cash flows have a completely general variance-covariance structure. (2005) artificially decompose information into “market” and “idiosyncratic factors.11 We model a more general information structure that allows us to examine alternative covariance structures. Analysts’ forecasts of future earnings are also about the earnings of the entire firm. the betas and covariances are relative to the exogenously specified “common factors. It is also consistent with virtually all papers in the noisy rational expectations literature in accounting and finance (see Verrecchia. other disclosures such as revenues or a cash flow statement are typically for the firm as whole.12 Similarly. Depending on the correlation structure assumed about the cash flows ~ and error terms. as well as informative in updating the assessed variances and covariances of end-of-period cash flows. for a review). industry. This formulation of information is consistent with the way information is modeled in virtually all conventional statistical inference problems (see DeGroot. Z j . In particular. whereas in Hughes et al. an observation. Firms’ earnings provide information about the sum of the market. In contrast. the betas and covariances that turn out to be relevant in our pricing equations are relative to the market portfolio (the sum of all firm’s cash flows). Specifically. 2001.” 19 .” Moreover. we model information as representing noisy measures of the variables of interest. which are end-of-period cash flows. That is. whereas the analysis in Hughes et al. and idiosyncratic components of their future cash flows. where ε j is the “noise” or “measurement error” in the information. Similarly. 1970).models. Vj .

we can show that the information Z j leads to an updated assessed covariance ~ ~ between the two cash flows V j and Vk . Vk ) and closer to zero as the precision of firm j’s information increases. V j . Proposition 2. 20 . Foster.There is also substantial empirical support for the notion that the earnings of a firm can be useful in predicting future cash flows of the industry or the market as a whole. the posterior variance of V j becomes smaller as the precision of Z j increases. which is noisy information about firm j’s future cash flow. The covariance between the cash flows of firms j and k conditional on ~ ~ information about firm j’s cash flow moves away from the unconditional Cov (V j . 1992). Piotroski and Roulstone (2004) document how the activities of market participants (analysts.. In particular. industry and market components of future earnings into prices. which is non-zero. As far back as Brown and Ball (1967) studies have documented substantial market and industry components to firms’ earnings. Hand and Wild. ~ Moreover. it is not necessary that there be a “large” effect of firm j’s disclosures on individual other firms. and insiders) impact the incorporation of firm-specific. Specifically. 1990. institutional traders. it is straightforward to show that the updating takes the following form. 1981.Vk ) . Freeman and Tse. Bhoraj et al. (2003) extend this finding to other firm-level variables and financial ratios. Suppose further that we ~ ~ observe Z j . As in the previous ~ ~ section. The “information transfer” literature also documents relationships between earnings announcements by one firm and the earnings or stock price returns of other firms (e. Consider first the case of two firms and suppose that the future cash flows of the two ~ ~ firms have an ex-ante covariance of Cov (V j . As we show.g.

Var ( Z j ) (6) ~ ~ Therefore. then observing Z j is the ~ ~ ~ ~ same as observing V j . times a factor that can be interpreted as the percentage of the variance of the information signal that consists of noise or measurement error. the conditional covariance between V j and Vk is equal to the unconditional covariance. More generally. ∑ ∑ j k j j k j ∑ Vk ). this is no longer a source of common variation between the two cash flows. But if V j is observed. Once both cash flows are re-assessed based on this information. The intuition is as follow. the assessed covariance goes to zero. At the other extreme. % % Var ( Z ) Var ( Z ) k =1 k =1 k =1 J j j Therefore. This implies that J Var (ε J %j ) %j ) Var (ε % % % % % % = = Cov ( V . hence. there is no reason to update ~ ~ an assessment of the unconditional variance of V j . if there is no measurement error in Z j . or the unconditional covariance between V j ~ ~ ~ and Vk . there is no further covariation between V j and Vk . so the covariance of the cash flows declines. the assessed covariance between V j and Vk decreases (in absolute value). the conditional covariance between the cash flows of firm j and those of the market as a whole is proportional to the amount of measurement error in the information about 21 .Vk ) ~ .~ ~ ~ ~ ~ Var (ε j ) Cov (V j . Therefore. If there is infinite measurement error in ~ ~ Z j . ~ ~ ~ As the measurement error in Z j goes down. Proposition 2 applies equally to the conditional covariances with all other firms in the economy. V ) Cov ( V . then observing Z j does not communicate anything.Vk | Z j ) = Cov (V j . providing improved information about firm j’s future cash flow implicitly also provides information about firm k’s future cash flow. V | Z ) Cov ( V .

” which is commonly used in finance. such as more precise information. We can also express our findings for the (special) case where the distribution of cash flows is represented by a “single-factor index model. ~ Suppose that the cash flow for firm j is V j = a j + b jθ + u j . which implies Variance ( Z j ) 22 . Let the ~ ~ ~ information about firm j be a noisy measure of its cash flow. this effect does not diversify away in large economies: the effect is present for each and every covariance term with firm j. ~ ~ As the measurement error in Z j goes down. and the conditional covariance given Zj is Variance (ε j ) ~ ~ Cov (V j . Moreover. and thus increases that firm's cost of capital. reduces the premium. the assessed covariance between V j and ∑ V% k =1 J k moves closer to zero. improved information will increase the firm’s cost of capital. where θ is a “market factor” and uj is a firm specific factor. For convenience. as well as each other. let all the uj’s be distributed independently. Z j = V j + ε j .Vk | Z j ) = b j bkVariance (θ ) . where the error terms are distributed independently of the true cash flows. Note that Proposition 2 does not require that the unconditional covariance be positive.firm j’s cash flow. then the conditional covariance increases toward zero. The reason for the increase is that a firm with a negative (unconditional) covariance between its cash flow and the market cash flow sells at premium reflecting that it offers a counter-cyclical cash flow. Anything that makes the negative covariance less negative. In this case. irrespective of its sign. If the unconditional covariance is negative. Then the unconditional covariance between the cash flows of firms j and k is bjbkVariance(θ).

The insights from our analysis apply as 23 . Variance(ε j ) ~ | ) ( ) θ V Z b Variance = ∑ k j j ∑ bk . In fact. in our paper we interpret information as being related to the realized future cash flow. nonetheless. In that case. As noted above. Our analysis does not rely on the (somewhat arbitrary) distinction between estimation and fundamental risk. It is straightforward to incorporate a limit on how precise the information can be regarding future cash flows and our results continue to hold. We could also conduct the analysis by interpreting information instead as signals about the expected future cash flow (or about parameters of the distribution of future cash flows). our information structure implies that an infinitely precise information system perfectly reveals a firm’s future cash flow. Consistent with the way information is modeled in most of the rational expectations literature.~ Cov(V j . another possible extension is to change the underlying construct that governs information. Of course. as opposed to the realized future cash flow. a perfect signal no longer resolves all uncertainty. One interpretation of this limit is that it represents the distinction between “fundamental” or “technological” risk. the posterior covariance between firm j and “the market” gets closer to zero as the quality of the information about firm j’s future cash flow improves.” While this distinction has some intuitive appeal. Similarly. even “fundamental risk” is conditional upon the information system available. when learning about the expected future cash flow. it would continue to hold if such a distinction were modeled formally. in reality we would not expect even the most precise disclosure and accounting system to remove all uncertainty about a firm’s future cash flow. most of the estimation risk literature interprets information this way. as opposed to “estimation risk. Of course. the remaining uncertainty could be interpreted as “fundamental risk” as discussed above. Variance( Z j ) k≠ j k≠ j As before.

a natural extension of Proposition 2 is to consider the impact on the covariance of both firms providing information. the nature of the cross-sectional impact on the covariance. Hughes et al. (2005). by definition. we find that virtually any more general representation of firms’ cash flows and information will change the covariance of ~ ~ V j and Vk . so they cannot be useful in updating the assessed covariance. While this result is similar in some ways to ours. Our finding that information affects the assessed covariance between firms’ cash flows are in contrast to those in a concurrent paper by Hughes et al. For example. That is. which employs more restrictive and less natural information structures. When the measurement errors in the 24 . or 2) the expected future cash flows and the covariance matrix are both unknown. show that if the information concerns exclusively the idiosyncratic component of a firm's cash flows. the information is. For example. under these conditions. also considers an information structure that relates only to the “common factor” portion of cash flows.long as some residual uncertainty remains. When the information is about the firm’s cash flow as a whole. Hughes et al. In this case. not the cash flows per se. the covariance between the cash flows of any two firms that are both affected by this common factor will also change. Similarly. information does affect the covariance between a firm’s cash flows and the common factors. and therefore the cost of capital. and the information matrix is exclusively diagonal then there is no covariance effect. unrelated to the component of cash flows that varies across firms. differs in their paper because of the different information structure assumed. We could also repeat the analysis under alternative assumptions regarding which parameters of the distribution of future cash flows are uncertain: 1) the expected future cash flows are unknown but the covariance matrix is known.

One possibility is to assume that the correlation. lowers proportionately the covariance between the error terms in the information firms j and k’s provide. ρ. we claim that in general information about firm cash flows (or other measures of 13 See the discussion of the Corollary that follows the proof to Proposition 2 in the appendix. 25 . but signing the effect is more difficult. While the equation is difficult to sign in general. Thus. the analysis in Proposition 2 extends easily.information across firms are conditionally uncorrelated. between measurement error terms remains constant. we provide in a Corollary to Proposition 2 (see the Appendix) sufficient conditions for a decrease in the measurement error of firm j’s accounting information to move the conditional covariance between firm j and k’s cash flow toward zero. In general. it important to be able to specify how the covariance between the measurement errors in firms’ disclosures changes as the quality of one firm’s accounting information improves. It seems intuitive that firms using the same (imperfect) financial reporting principles have correlated measurement errors.13 Another interesting extension is to analyze the case of correlated measurement errors in the accounting information across firms. in order to carry out any analysis. as well as correlated cash flows. so that the covariance between the two measurement error terms is equal to this correlation coefficient times the standard deviations of the two firms’ error terms. In particular. the conditional covariance of firm j’s cash flows will still be affected by the amount of measurement error in both firm j’s and firm k’s accounting information. lowering the measurement error in firm j’s disclosure. In this case. Unfortunately there is little precedent in the statistical decision theory literature or the estimation literature in finance for how to model information when key elements are correlated. the variance of εj in our notation.

3 The Effects of Mandatory Disclosures In the previous sections. the covariance between the cash flows of firms j and k. This positive externality provides potentially a reason why there could be benefits to disclosure regulation. It is important to point out that. and Admati and Pfleiderer (2000) for other externality-based explanations of mandatory disclosure.15 Based on our framework and prior results. if each firm discloses the aggregate market cash flow with idiosyncratic noise. That is. increasing the quality of mandated disclosures should in general reduce the cost of capital for all firms in the economy (assuming that the expected cash flow of each firm in the economy and the covariance of that firm’s cash flow with In contrast. we analyze the impact of changing the quality of accounting information for a single firm on its price and cost of capital. it is not necessarily the case that the uncertainty about the market cash flow is eliminated. say.14 3. because firms will not take this externality into account when deciding the optimal level of voluntary disclosure. and there would be no aggregate uncertainty. The main difference is that disclosure regulation affects all firms. Dye (1990). firm k’s disclosures have an additional impact on this covariance. Therefore. 14 26 . If each firm discloses its realized cash flow with noise. the disclosures of many firms would in the limit reveal the market cash flow. however. and hence leads to cross-sectional differences in firms’ cost of capital. it could become large collectively. even in the case where all firms provide information. in addition to the impact of firm j’s disclosure on. We now briefly discuss the effects of mandatory disclosure of accounting information. is not very descriptive of what firms do. each firm’s disclosure generates an externality on other firms’ cost of capital.firm performance) has a covariance effect. This information structure. uncertainty about the market cash flow will grow as the number of firms in the economy grows. 15 See Fishman and Hagerty (1989). While this effect is small individually. In principle. disclosure by every other firm could have a (small) impact on its covariance with firm j. rather than relying on voluntary disclosures.

that the impact of information is on the assessed distribution of cash flows.16 Moreover. It is more natural to assume. The precise effect. Therefore. Even if mandatory disclosures affect all elements of the covariance matrix of future cash flows by a scale factor.. In addition.the market have the same sign). may depend on how the covariances of the measurement errors are affected and hence is subject to the discussion at the end of the previous section (see also the Corollary to Proposition 2). there was no affect on the beta coefficient of returns. and some found that information would not affect the betas of firms. The amount of new information provided by a particular mandated disclosure depends on what other information the firm already discloses. 1971. In particular. it follows from the pricing formula in eqn. Therefore. (2) that the cost of capital depends on the ratio of the firm’s expected cash flow to its covariance with all cash flows. for others it may provide a small amount of incremental information. the prices of all firms will not change proportionately. See Coles and Lowenstein (1988) for similar discussion. Brown. 16 27 . using eqn. their expected cash flows would be unlikely to have the same scale factor. which is the ratio of the covariance of the firm’s return to the market divided by the variance of the market return. Even if all firms’ covariances were affected proportionately. For some firms. however. because the numerator and denominator changed by the same scale factor. it seems unlikely that mandated disclosures would alter the entire covariance matrix of all firms’ future cash flows by the same scale factor. This result occurred because (by assumption) all the covariances and variances of firms’ returns changed proportionately. not returns. the effect on the cost of capital is not proportionate for all firms. however. 1979) assumed that information had a proportionate impact on the covariance matrix of returns. Kalymon. Thus.g. this disclosure requirement duplicates other disclosures. These information effects imply an unequal impact of disclosure regulation on the individual elements of the Some early models in the estimation risk literature in finance (e. in which case it provides no additional information. the magnitude of the impact of mandatory disclosure on a particular firm’s cost of capital is less clear-cut. (4). the firms’ expected returns (and cost of capital) will not change by the same proportion for all firms either. and for others still it may be completely new.

Therefore. It is important to distinguish between the impact of mandated disclosure on the cost of capital and the impact on the beta coefficient. Clearly. Indirect Effects of Information on Cost of Capital In this section. Instead. 4. In fact. mandated disclosure cannot reduce all firms’ betas. as we showed in Proposition 1. the average beta in the economy must still be 1. so will their decisions. Thus.covariance matrix of future cash flows. if the ratio of the firm’s expected cash flow to the covariance between 28 .0. Our formulation allows us to express the cost of capital in a reduced form that depends on assessed covariance between the cash flow of the firm and the cash flows of all firms in the market. we show how the quality of the accounting and disclosure system has an indirect impact the firm’s cost of capital through its effect on real decisions that impact the expected cash flows and covariances of cash flows. decision-makers in an economy make decisions on the basis of the information they have available to them. This insight suggests that researchers interested in examining the effect of mandated disclosures on costs of capital must look beyond the beta coefficient and examine aggregate measures such as the average cost of capital in the economy or the market risk premium. In particular. this impacts the firm’s cost of capital. To the extent these new decisions alter the distribution of the firm’s end-of-period-cash flow. it does not imply a reduction in the beta coefficient separately. If this information changes. Even if mandated disclosure reduced the cost of capital for firms. this does not imply that all beta coefficients will be similarly reduced. firms are likely to be affected by mandatory disclosures differentially. the lowered covariance between end-of-period cash flows implies a reduction in the product of the impact on the market risk premium and the beta coefficient. regardless of the quality of the information environment.

and 2) the impact of these decisions on the distribution of future cash flows. so will its cost of capital. In addition to the decisions of investors and creditors. An exception is Lombardo and Pagano (2000). Governance. accounting information affects the amount of cash that is appropriated from investors. a firm’s accounting and disclosure systems may affect managerial actions. In one. regulatory authorities.the firm’s cash flow and the sum of all other firms’ cash flows changes (our parameter H in our Lemma 1). and by definition. 4.. but do not affect the cost of capital as defined by the discount rate implicit in the firm’s stock valuation.g. In the second. We provide two simple examples to illustrate these issues. 29 . as they also analyze the impact of governance and appropriation on firm’s cost of capital.g. however.. accounting information changes a manager’s investment decisions. These papers. etc.1 Information. in agency theory) have suggested that better financial reporting and/or corporate governance increases firm value by reducing the amount that managers appropriate for themselves (e. The potential scope of the decisions that a firm’s accounting and disclosure systems may affect can be broad. do not discuss the impact that these systems have on the firm’s cost of capital. Lambert. LaPorta et al. 1997.. To be able to predict the “indirect effect” of accounting information on the firm’s cost of capital therefore requires the researcher to carefully specify: 1) the link between information and these decisions. some of them claim that these systems have a “one-time” effect on price. We compare our model and results to Lombardo and Pagano (2000) below. and Appropriation Many papers (e. the expected rate of return on the firm’s stock will change. The impact on the firm’s cost of capital can be either positive or negative. In fact. as well as the potential actions of competitors. 2001).

we assume this cash flow has a normal distribution. where Q is the quality of the accounting and disclosure system. 18 17 30 . Lombardo and Pagano (2000) analyze a model that also has a parameter analogous to our A1.18 A higher quality accounting system is assumed to reduce the amount of ′ ≤ 0 . we have suppressed the subscript j on the parameters A0 and A1. This fee is proportional to the share price. however. This representation allows us to calculate the expected value of the firm’s cash flow and its covariance with other firms’ cash flows as a function of the quality of the information and/or More generally. whereas these are not issues addressed in Lombardo and Pagano (2000).~* Represent the “gross” end-of-period cash flow of firm j before any appropriation by V j . which reduces the cash flow available to shareholders by a fractional amount. we do not mean simply the disclosures the firm makes to outsiders. that corresponds exactly to our A0. they have a cost that shareholders pay out of their own pocket for auditing and legal fees. but these features are not necessary to make our point. By accounting systems here. Managers appropriate for themselves an amount A that decreases with the quality of the information and/or governance systems. whereas ours can be firm-specific. As before. the amount a manager could appropriate would also depend on dimensions of the legal system. the amount of the firm’s end-of-period cash flows that is appropriated from shareholders is A(Q) = A0 (Q) + A1 (Q)V j* . which reduces the end-of-period cash flow by a constant.17 Clearly. Note that for convenience. They do not have a parameter. such as the ability to bring lawsuits against the firm and/or managers. A1 is between 0 and 1. a more sophisticated analysis could be conducted that endogenously derives the functional form of A and/or determines the types of information that lead to the largest reductions in A. This means that the net amount received by the firm’s misappropriation: A ′ 0 ≤ 0 and A1 shareholders is ~ ~* ~* Vj =Vj − A(Q ) = (1 − A1(Q ))V j − A0 (Q ). we explicitly analyze the impact the appropriation parameters have on the riskiness of the end-of-period cash flow (variances and covariances). A0 is non-negative. Another difference is that in their model appropriation parameters are economy-wide (or for segments of the market). etc. corporate governance policies. Instead. Finally. which obviously depends on the expected end-of-period cash flow. In particular. but also internal control systems. and V* is the value of the firm gross of any appropriation.

suppose the quality of information affects only the “proportion” of the firm’s cash flow the manager appropriates: the parameter A1. improved information moves the cost of capital closer to the risk-free rate. the ratio of expected cash flow to covariance of cash flows does not change. then information has no effect on the cost of capital. Therefore. Q. One special case arises when the quality of the information and/or governance system affects only the “fixed amount” (A0) the manager appropriates. increasing the quality of the accounting system increases the expected cash flow available to shareholders by reducing A0. In 19 31 . and the firm’s cost of capital is unaffected. As in the previous section. Therefore. the impact of the firm’s own variance on the cost of capital goes to zero as the number of investors gets large. Otherwise. improving the quality of the firm’s information and/or governance system increases the proportion of the firm’s cash flow available to shareholders. not surprisingly. At the other extreme. Proposition 3. but it also increases the covariance of the firm’s cash flows with other firms by the same proportion. This not only increases the firm’s expected cash flow. the total covariance does not change in exact proportion to the expected value because the firm’s covariance with itself will change with the square of the proportionality factor.19 Lombardo and Pagano (2000) establish a similar result: Technically. It does not affect. If A0 = 0 and A′ 0 = 0 (so that information only affects the A1 term). In this case. however. What is more surprising is that the information system also leads to a change in the firm’s cost of capital. a higher quality accounting system increases the price of the firm.governance quality parameter. Our model shows that the reason is straightforward: the ratio of the expected cash flows to the covariance shifts. In this case. Higher quality information that reduces managerial misappropriation of the firm’s cash flow weakly moves the firm’s cost of capital toward the risk-free rate. the covariance of the firm’s net cash flows with those of other firms. We can then apply Lemma 1 to determine the effect on the firm’s cost of capital. however.

if improved disclosure shifts only the “fixed” component of managerial misappropriation. and strictly increases the firm’s cost of capital. as opposed to by the manager. in which case the impact on the cost of capital will be approximately zero. and in this case increased disclosure quality weakly increases the firm’s cost of capital. In this case. but there is no impact on the firm’s expected rate of return given this “one time” effect on price. Proposition 3 indicates that the assumption that the manager’s appropriation is exactly a fixed proportion of the end-of-period cash flow is the only situation in which there is no impact on the cost of capital. increased disclosure allows other firms to make better strategic decisions to compete away some of the profits of the disclosing firm We can adapt our model to this situation by assuming that increased disclosure quality will increase A0 or A1. As long as there is a component of appropriation that does not vary with the realization of the end-of-period-cash flow (for example. this case. A common assumption in the literature for the functional form of the proprietary costs is that they reduce profits by a constant (e. firms’ cost of capital decreases. suppose improved accounting and disclosure influences the governance of all firms. In this literature. the impact of an improvement on the firm’s expected cash flows will be approximately proportionate to the change in the overall covariance. This allows us to tie our results to the large literature in accounting on the proprietary costs of disclosure (see Verrecchia. as in a mandatory change such as the Sarbanes-Oxley Act of 2002. Finally. We can also interpret the parameters A0 and A1 as cash flow appropriated by other firms. 2001). 1983). there will be a non-zero impact on the cost of capital. or the quality of information affects the “fixed” component of appropriation. 32 .. the impact of the indirect effects on the cost of capital is ambiguous.g. improved accounting information and disclosure increases A0. The comparative statics are straightforward. In fact. if it depends on the expected future cash flow instead of its realization).price increases. Again. Verrecchia. As above.

because the cash flows of all firms shift proportionately. if the accounting system affects the firm’s cost of capital (for the reasons discussed 20 We thank the anonymous referee for pointing this out to us. the risk increases faster than the expected payoff from the market (by a factor of (1-A1)2 versus 1-A1).20 As above. But this implies that there is more risk in the economy. Aggregate prices will generally increase. however. the reason is straightforward. However. the firm’s expected cash flow rises by a factor of (1-A1). When the quality of information and/or governance is poor. so the aggregate risk premium goes up. they also absorb a considerable amount of risk. Therefore. this means that the quality of the accounting system does not change the manager’s production or investment decisions. In this case. in addition. managers steal less. When accounting quality increases. as well as the cost of capital. Implicitly. so more of the payoff goes to shareholders. however. and investors will achieve higher expected utilities. 33 . 4. and this extra risk is perfectly correlated with the existing risk. It is important to note that this result does not mean investors are worse off.The results are different. for the case where improved disclosure impacts only the proportion (A1) of the cash flow appropriated by the manager. Managers do not mind bearing this risk because they did not have to pay anything to acquire the appropriated payoff.2 Information and Investment Decisions In the analysis above. While this result might seem unintuitive. There are reasons to suspect that a change in the quality of the accounting system has an impact on the firm’s real decisions. managers appropriate a considerable amount of the payoff. mandatory disclosure increases the firm’s cost of capital. the covariances of cash flows increase by a factor of (1-A1)2. the quality of the reporting system does not affect the “gross cash flow” generated by the firm. For example.

The marginal productivity of investment. which implies that the cash flow distribution satisfies: ~ ~ | Z) − . where the period cash flow is quadratic in the amount produced (invested): V j = kπ j ~ . Next. k. ∑Vk | Z) = k (Z)Cov(π j ∑ k k≠ j ~ ~ Note that both the variance of firm j’s cash flow and the covariance of its cash flows with other firms are increasing in k (assuming the covariance is positive). E (V j | Z) = k ( z ) E (π ~ ~ | Z) . to align the interests of the manager with that of investors.5k 2 ( Z) . about the marginal productivity of investment before he makes his decision. is uncertain at the time the investment is made. k≠ j ~ .in the previous section). This happens even in the absence of any concerns about agency problems. π j ~ manager observes a noisy signal. then the investment (or investments) that the firm views as optimal is also likely to change. V | Z) . based on information he has about the profitability of the investment. Using eqn.5k 2 . (3). the manager maximizes share price. This observation (which could constitute a report or a forecast) is also ~ is normally distributed conditional disclosed subsequently to investors. and Var (V j | Z) = k 2 ( Z)Var (π j ~ Cov(V j . we abstract from agency considerations and assume that.21 We assume that π j upon Z. the manager chooses the investment level k ( Z) to maximize the beginning-of-the-period price of the firm. 21 34 . To provide a simple example. That is. his objective function becomes We can vary how much information the manager has relative to investors without changing the qualitative nature of the result. The end-of~ ~ − . Z j = Z. assume the manager decides on a production or investment quantity.

increases the variance and covariances.g. not just the perceptions of these cash flows by market participants. this lowers the cost of capital. ∑ Vk | Z)⎥ ⎥ j | Z) − 1+ Rf ⎢ Nτ ⎢ ⎥⎥ k =1 ⎦⎦ ⎣ ⎣ ~ | Z) − . The equilibrium is then the net of these two effects. Tobin. rather than decreases it. ~ 1+ R f k * ( Z) = k≠ j ∑Vk | Z) . Given this function. 22 35 .22 In essence. In our example. the conditional variance and the conditional covariances decrease. k ( Z) E (π j j Nτ = The optimal investment level then becomes ~ | Z) − 1 Cov(π ~ . 1982). which increases the cost of capital. higher information quality improves the coordination between firms and investors with respect to capital investment decisions. Anticipating this effect. as the quality of information improves.Maximize k ( z) J ⎤⎤ 1 ⎡ 1 ⎡ ~ ~ ~ ⎢ E (V ⎢ Cov(V j . Eqn. This increase in k * ( Z) . E (π j Nτ 1+ k≠ j ∑Vk | Z) . investors demand a lower expected rate of It would be interesting to examine more general investment / production decision settings to see whether there are conditions under with the “indirect” effect dominates the “direct effect” so that an increase in the quality of the firm’s accounting system actually increases the firm’s cost of capital. (7) ~ 2 ~ | Z) Var (π j Nτ From the previous section.. however. Other things equal.5k 2 ( Z) − 1 {k 2 ( Z)Var (π ~ | Z) + k ( z )Cov(π ~ . information quality is important because it affects the market's ability to direct firms’ capital allocation choices. that this also causes the manager to become more aggressive in his investment choice. As a consequence. Stated somewhat differently. the overall effect decreases the cost of capital. this example captures the notion that equity markets play a role in allocating capital and directing firms' investment choices (e. (7) shows. in turn. information quality changes firms’ future cash flows.

As the discussion above suggests. we cannot sign the overall impact without placing more structure on the analysis.return. and how compensation schemes should consider idiosyncratic and nondiversifiable risks. In short. For example. and how this then affects the cost of capital to shareholders. we can sign the overall impact on the cost of capital as long as the expected value does not change “too much” relative to the change in the covariance. a change in accounting and disclosure systems affects the variances and covariances both directly and indirectly through real decisions. (2002) examine how “idiosyncratic” risk affects managers’ investment decisions. Obviously. For example. this involves modeling and analyzing the incentive mechanisms used to motivate the manager and monitor his decision. When there are agency problems between firms and managers. When these two factors move in the same direction. the overall impact on cost of capital can be signed when the effects are reinforcing. that is. It would be particularly interesting to examine the interaction between firm-specific factors and cost of capital in such a setting. however.. Future research could explore how the cost of capital charged to managers via compensation schemes influences their investment choices. 36 . When a change leads to a shift in both the expected value and the covariances. investors price the risk of misalignment or misallocation that stems from poor information quality. We leave this to future research to explore. the quality of the firm’s accounting and information system also affects the magnitude of these agency problems. and further changes the equilibrium production and investment decisions. when expected cash flow and the overall covariance with all firms’ cash flows move in opposite directions. Christensen et al. We formalize this notion in the next proposition.

an increase in σ without any increase in µ results in an increase in the firm’s cost of capital. Then the overall impact of a change in σ on the firm’s cost of capital has the same sign as the term. and the cost of capital increases. Let µ denote the expected cash flows and σ denote the covariance of the firm’s cash flows with those of the market given an information system and the decision that results from that information system. suppose that the expected value is related to the covariance through the following functional form: µ = ψ 0 + ψ 1σ . Note that this ratio can also be interpreted as the inverse of a measure analogous to the coefficient of variation of the cash flows. 37 . where ψ0 and ψ1 are arbitrary positive constants. whereas a decrease in σ results in a decrease in the cost of capital. these effects reinforce each other. In particular. just as in Proposition 1. µ − µ′ . Similarly. not its own variance per se that is relevant. σ For example. Then we can use Proposition 4 to show that an increase in σ leads to an increase in the cost of capital. Let µ ′ be the change in µ that accompanies the change in σ. Proposition 4 places a bound on the extent of the impact on µ.Proposition 4. the impact on µ cannot exceed the ratio of the mean to the covariance. When σ and µ change in the same direction. if σ increases while µ decreases. For example. except it is the contribution of the firm to the overall variance of the market. An alternative way to state the condition in Proposition 4 is that the overall impact of a change in σ on the cost of capital is positive (negative) if d ⎡µ ⎤ ln ⎥ is less than (greater than) dσ ⎢ ⎣σ ⎦ zero.

despite the forces of diversification. Once we 38 . we examine whether and how the quality of a firm’s accounting information manifests in its cost of capital. but expressed in terms of cash flows. we demonstrate that the quality of accounting information influences a firm’s cost of capital. Their paper only analyzes the direct effect of information. The direct effect occurs because the quality of disclosures affects the assessed covariances between a firm’s cash flow with other firms’ cash flows. Conclusion In this paper. rather than returns. information has no cross-sectional effect. Using this framework. Our finding provides a direct link between the quality of a firm’s disclosures and accounting policies and its cost of capital.5. and concludes that only the market-wide risk premium changes. In addition. Hughes et al. whereas we use the more conventional definition of the expected rate of return on the firm’s stock. (2005). Specifically. define cost of capital as the difference between beginning-of-period price and end-of-period expected cash flows. and indirectly by affecting real decisions that alter the distribution of future cash flows. One reason for the apparent contrast to our results is the different definition of cost of capital. We augment this model with an information structure where accounting information and firms’ disclosure policies are represented as noisy information about firms’ future cash flows. In particular. we develop a framework that links the disclosure of accounting information to the cost of capital. Our result that accounting information can lower a firm’s cost of capital contrasts with contemporaneous work by Hughes et al. This effect is not diversifiable in large economies. it extends prior work in the estimation risk literature. We build a model of a multi-security economy that is consistent with the CAPM. both directly by affecting market participants’ perceptions about the distribution of future cash flows.

cross-sectional effects on cost of capital manifest. But this justification is different from one where additional variables are included in the empirical specification to capture an “information risk” factor outside the one-factor CAPM. We show the indirect effect can go in either direction. Moreover. our model does not provide a theoretical justification for an “information risk” factor. however. That is. but also derive conditions under which an increase in information quality leads to an unambiguous decline in a firm’s cost of capital. there would be additional crosssectional differences in the effect of information on the cost of capital. Alternatively. into our definition of cost of capital. First. the direct and indirect effects that we discuss are entirely consistent with the CAPM. if indirect effects such as those we consider were introduced into Hughes et al. The nature of the cross-sectional effects differs from ours. As a consequence. the ratio of a firm’s expected future cash flows to the covariance of these cash flows with the sum of all firms’ cash flows changes. The indirect effect occurs because disclosure quality can change a firm’s real decisions. are unlikely to capture all information effects on the forward-looking beta. Empirical studies that are based on our results should therefore focus first on the link between information quality and the beta factor. These results have a number of important empirical implications. which are based on historical returns. due to the differences in the information structures assumed. Therefore. researchers could appeal to the notion that empirical proxies for beta.translate results from Hughes et al.. researchers should specify a “measurement error” model or. If they adopt this justification. but they need to be carefully interpreted. This ratio is a key determinant of a firm’s cost of capital. over and above beta. the information effects demonstrated in this paper are fully captured by an appropriately specified forward-looking beta and the market-wide premium for risk. at least. provide careful 39 .

whereas empirical studies are often conducted cross-sectionally for a number of firms. mandated disclosure may reduce the covariance of one firm’s cash flows with the sum of the cash flows of all firms faster than for other firms. Nonetheless. disclosure regulation is likely to affect firms’ assessed covariances with other firms differentially. Because mandated disclosure impacts the covariances of all firms with each other. Second. hence. empirical researchers should exercise care in interpreting our analysis of the indirect effects of information quality. Based on our model. we briefly comment on the impact of mandated disclosures or accounting policies on firms’ cost of capital. Finally. it is possible that the indirect effects will have different directional effects across firms.reasoning why and how the information variables help in capturing measurement error in the forward-looking beta. which could obscure positive indirect effects for some firms and negative indirect effects for others. empirical studies will generally measure the sum of the direct and indirect effects of information quality. Moreover. Unless the researcher is careful to specify what decisions are affected and build these directional predictions into the empirical analysis. In a crosssectional setting. a significant portion of its impact on the cost of capital of firms occurs through lowering the market risk premium. increasing the quality of mandated disclosures should generally reduce the cost of capital for each firm in the economy (assuming that the expected cash flow of each firm and the covariance of that firm’s cash flow with the market have the same sign). Our analysis takes place at the firm level. the empirical analysis may mistakenly conclude that there are no indirect effects. For example. the researcher will estimate the “average” indirect effect. The effect of mandated disclosure on firms’ beta factors is more difficult 40 . That is. the benefits of mandatory disclosures are likely to differ across firms.

The betas of those firms whose covariances of cash flows with the sum of the cash flows of all firms decrease relatively faster are likely to fall. mandated disclosure cannot lower the beta coefficients of all firms because beta coefficients measure relative risk.to predict. In particular. while mandated disclosure generally results in each firm having a lower cost of capital. 41 . while those whose covariances decrease relatively slower are likely to rise. and hence must aggregate to 1. its impact on betas is ambiguous.0 regardless of the information set available to investors. Therefore.

Consider an economy with J ﬁrms. Each investor has a negative exponential utility function: that is. and a riskfree bond.. where Dij represents her endowment in µ ∙ ¸¶ → c. Now consider the market price for ﬁrm j that prevails in a perfectly competitive market in which N investors compete to hold shares in each ﬁrm. where τ > 0 describes each investor’s (constant) tolerance for risk.. . indexed by the subscript i = 1. an investment ˜j and Pj represent the of $1 in the risk-free bond yields a return of $1 + Rf . DiJ } represent the 1 × J vector of investor i’s bond.. Let V uncertain cash ﬂows of ﬁrm j and the market equilibrium price of ﬁrm j . Di2 ...... where Dij represents investor i’s demand for ﬁrm j ∗ ∗ ∗ ∗ ∗ ¯i expressed as percentage of the total ﬁrm. Along with the J ﬁrms. Let U (c) represent investor i’s utility preference for an amount of cash c. Di2 . We assume that the risk-free rate of return is Rf .. U (c) is deﬁned by 1 U (c) = τ 1 − exp − c τ µ ∙ ¸¶ .... We represent investors’ (homogeneous) knowledge about ﬁrms’ cash ﬂows by Φ. let D = Di 1 . indexed by the subscript j = 1. 2. U (c) converges asymptotically to risk neutrality: 1 lim c U ( c ) = lim τ 1 − exp − τ →∞ τ →∞ τ In addition. .. N . as well as a risk-free ¯ i = {Di1 . J . 2. n o 41 . U (·) is standardized such that U (0) = 0. we introduce a perfectly competitive market for ﬁrm shares comprised of N investors. Note that this characterization of the negative exponential has the feature that as risk tolerance becomes unbounded. ..APPENDIX Proof of equation (3). Dij . .. .. respectively.. . Dij . where N is large. that is.. DiJ represent ∗ her vector of endowed ownership in ﬁrms. Let D demand for ownership in J ﬁrms.

t-th term is Cov V The ﬁrst-order condition that maximizes eqn. Thus. .. Pj .. (A3) N X J ³ h i ´ h i X ˜k |Φ .. P2 . ∗ ¯0 ¯i P + Taking the expectation of eqn. .Bi τ D h i h i ˜2 |Φ − (1 + Rf ) P2 .Bi τ D subject to the budget constraint ∗ ¯0 ¯ iP ¯ 0 + Bi = D ¯i D P + Bi∗ . .. ¯ i . where once again Pj represents the price of ﬁrm j . .. E V ˜J |Φ − (1 + Rf ) PJ }0 E V 1 1 ¯ ¯0 ∗ ¯0 ¯i + (1 + Rf ) D P + (1 + Rf ) Bi∗ ) + Di ΛDi ]). VJ } + (1 + Rf ) Bi )])|Φ] ¯ i . for each k it must be the case that with respect to i yields PN i=1 Dik = 1. 0=E V Dik Cov V τ k=1 (A3) Because collectively investors have claims to the cash ﬂows of the entire ﬁrm. summing over both sides of eqn. respectively..¯ = {P1 . ˜s · V where Λ is an J × J covariance matrix whose s. (A1) and substituting in the relation Bi = D (A1) ¯ 0 yields the following expression ¯ iP Bi∗ − D h i 1 ¯ ˜ max τ (1 − exp[− (D i {E V1 |Φ − (1 + Rf ) P1 .. PJ } ﬁrm j expressed as a percentage of the total ﬁrm.. and let P represent the vector of ﬁrm prices.... Let Bi and Bi∗ represent investor i’s demand for a risk-free bond and her endowment in bonds. V2 . (A2) with respect to Dij reduces to J h i h i X ˜j |Φ − (1 + Rf ) Pj − 1 ˜j · V ˜k |Φ . 2 τ2 h i (A2) ˜t |Φ .. ˜j |Φ − (1 + Rf ) Pj − 1 ˜j · V Dik Cov V 0=N E V τ i=1 k=1 or J i ´ h i 1X ˜k |Φ . Each investor solves 1 ¯ ˜ ˜ ˜ 0 max E [τ (1 − exp[− (D i {V1 . ˜ ˜j · V 0 = N E Vj |Φ − (1 + Rf ) Pj − Cov V τ k=1 ³ h 42 .

E. H= ˜j . and increasing Combining these. provided that H > 1. and ˜ εk each have a normal distribution and deﬁne Z ˜j = V ˜j + ˜ ˜k = V ˜k + ˜ ˜k as Z εj and Z εk . where When h i ˜j NτE V h i. we ˜ j is increasing in Rf . PJ ˜ Cov V k=1 Vk ˜j > 0 and Cov V ˜j . Q. ˜ ˜j and We assume that V εj . have E R Proof of Proposition 2. V h i # ˜j and N τ .D. E V h i " k=1 J X h i ˜k > 0. implies that the price for ﬁrm j is given by Pj = Q. h i ˜ j = Rf H + 1 . PJ ˜ H is increasing in both E V k=1 Vk . Note ˜ j with respect to H is negative: also that the derivative of E R ˜j ∂E R ∂H h i h i ˜ j is decreasing in both E V ˜j and N τ . Proof of Proposition 1.D. which is necessary for Pj > 0. PJ ˜ in Cov V k=1 Vk . Finally. Our only additional distributional assumption Z 43 h i h i h i (H − 1) Rf − (Rf H + 1) (H − 1)2 HRf − Rf − Rf H − 1 = (H − 1)2 1 + Rf = − < 0. in turn. From Lemma 1. ˜j .This. we have: E R ˜j . and decreasing in Cov V ˜j . V ˜k .E. E R H −1 ˜j |Φ − E V h i 1 Cov Nτ 1 + Rf h i ˜j · PJ ˜ V V | Φ k=1 k . (H − 1)2 = h i .

˜j .˜j and V ˜k are independent of ˜ is that V εj and ˜ εk . and Z ˜k have a 4-variate normal distribution these assumptions imply that V with an unconditional covariance matrix given by ⎡ h h i i h h i i h h i i h i ⎤ M =⎢ ⎢ ⎢ ˜k ˜ ˜j . V ˜k . Simplify the covariance matrix notationally by setting: V = V ar V ˜k . e = V ar [˜ ˜j . V Cov V εj . ˜ εk ] V ar V εk ] h i h ˜j . V C = Cov V εj ]. ˜ εk ] ⎥ ⎥ ⎦ h i h i i ˜k ˜j . V ˜k ⎢ Cov V ⎢ ˜k ˜ ˜j . V Cov V ˜j + V ar [˜ V ar V εj ] i i ˜j . V Cov V ⎢ V ar Vj ⎣ h i h i ˜j . ⎤ ⎥ ⎦. ˜ εk ]. V ˜k + V ar [˜ ˜k + Cov [˜ Cov V εj . but not of each other. Taken together. V Cov V ⎢ V ar Vj ⎢ h i h i ⎢ ˜k V ar V ˜j . U = V ar V ˜k . This implies ⎡ ⎢ V ⎢ ⎢ ⎢ ⎢ ⎢ ⎢ ⎢ ⎢ ⎣ ⎤ ⎥ ⎥ ⎥ ˜k ⎥ V ar V ⎥ ⎥. 44 . f = V ar [˜ εk ]. V Cov V C V C U M= C U C V C V +e C +c C U C +c U +f The inverse of M is ⎡ ⎢ ⎢ ⎢ ⎢ ⎢ ⎢ ⎢ ⎢ ⎢ ⎣ ⎥ ⎥ ⎥ ⎥ ⎥ ⎥. Z ˜j . ⎥ ⎥ ⎥ ⎦ f − ef − c2 c ef −c2 f ef −c2 c − ef − c2 c ef −c2 e − ef − c2 c − ef − c2 e ef −c2 UV f +U ef −U c2 −C 2 f V U ef −V U c2 −C 2 ef +C 2 c2 M −1 = − V Uef −V U c2 −C 2 ef +Cc2 c2 f − ef − c2 c ef −c2 Cef −C 2 c−Cc2 +U V −C 2 c−Cc2 +U V c − V UCef ef −V Uc2 −C 2 ef +C 2 c2 V eU +V ef −V V U ef −V U c2 −C 2 ef +C 2 c2 c ef −c2 e − ef − c2 c2 −C 2 e ⎤ Let m describe the submatrix m=⎢ ⎣ ⎡ UV f +U ef −Uc2 −C 2 f V U ef −V U c2 −C 2 ef +C 2 c2 −C 2 c−Cc2 +U V c − V UCef ef −V U c2 −C 2 ef +C 2 c2 V eU +V ef −V c2 −C 2 e V Uef −V U c2 −C 2 ef +C 2 c2 ⎥ ⎥ ⎥ ⎥ ⎥ ⎥. and c = Cov [˜ εj . h i ⎥ ˜k + Cov [˜ ˜j . V ˜k ˜k V ar V Cov V h i ˜j V ar V h h ˜k ˜j . ⎥ ⎥ ⎥ ⎦ Cef −C 2 c−Cc2 +U V c − V Uef −V Uc2 −C 2 ef +C 2 c2 ⎤ ˜j and V ˜k conditional on Z ˜j and Z ˜k is given by Then the covariance matrix for V m−1 = ⎢ ⎣ ⎡ V eU +V ef −V c2 −C 2 e V U +V f +eU +ef −(C +c)2 UV c+Cef −Cc(C +c) V U +V f +eU +ef −(C +c)2 UV c+Cef −Cc(C +c) V U +V f +eU +ef −(C +c)2 UV V U +V f +eU +ef −(C +c)2 f +Uef −U c2 −C 2 f ⎥ ⎦.

D. conditional on each ﬁrm disclosing information about their rej and k. Zk : that is.e. Zk = vur ˜j . V Cov V h i UV c + Cef − Cc (C + c) . V ˜k |Zj . Zk = Cov V h i ˜k |Zj . Zj and Zk . Corollary to Proposition 2: An Extension to Disclosure by Two Firms. V Cov V h i Here we analyze the special case where only ﬁrm j provides information about its cash ﬂow: the proof to Corollary 1 (below) considers the case in which ﬁrms j and k both report. In fact. V U + V f + eU + ef − (C + c)2 h i (A4) This expression clearly shows that a reduction in ﬁrm j ’s measurement error attenuates the unconditional covariance. V U + V f + eU + ef − (C + c)2 (A4) vu (1 − r2 ) ρ εφ + ε2 φ2 (1 − ρ2 ) r . V lim Cov V f →∞ e → C V +e h i V ar [˜ εj ] ˜j . becoming unboundedly large (i.˜j . Recall that from the proof of Proposition 2 the covariance of the cash ﬂows of ﬁrms ˜j and V ˜k . the conditional covariance reduces to ˜k |Zj ˜j . V spective cash ﬂows. v2 u2 (1 − r2 ) + (v φ − uε)2 + 2vuεφ (1 − rρ) + ε2 φ2 (1 − ρ2 ) (A5) 45 . f = V ar [˜ εk ].. is ˜j . measurement error in the variance in j ’s information determines the percentage of attenuation. In this case. f → ∞). ˜j + V ar [˜ V ar V εj ] = h i Re-expressing the conditional covariance in terms of (exclusively) standard deviations and correlations yields ˜k |Zj . Zk = ˜j . V ˜k |Zj . The oﬀ-diagonal terms in m−1 describe Cov V ˜k |Zj . V ˜k h i = Cov V . Firm j alone providing information is (mathematically) equivalent to the measurement error in ﬁrm k’s information about its cash ﬂow. Q.E. V Cov V h i UV c + Cef − Cc (C + c) . Zk ˜j .

and evaluate the derivative in a circumstance in which ﬁrms j and k are “otherwise identical”: that is. and the sign of the third term is determined by the sign of the correlation in cash ﬂows provided that the correlation is no less in magnitude than the correlation in disclosure errors: that is. ˜ εj and ˜ εk respectively. which requires r ≥ 0). Next. r. V ˜k |Zj . and the correlation in their disclosure errors about those cash ﬂows. U = u2 . assume that the correlations in cash ﬂows and disclosure errors do not have opposite signs. Zk with respect to the standard deviation in the ˜j . |r| ≥ |ρ|. V ˜k |Zj . Cov V ∂ε h i Note that this calculation requires that one ﬁrst compute ∂ Cov ∂ε then evaluate this expression at v = u and ε = φ: this is tantamount to a change in ﬁrm j ’s disclosure error holding ﬁrm k’s disclosure error ﬁxed. the sign of the second term is determined by the sign of the correlation in cash ﬂows. Then.. ε. e = ε2 . In other words. V the derivative of Cov V disclosure error in Zj . Zk |v=u. v = u and ε = φ). C = vur ≥ 0.ε=φ is determined by the V ³ ´³ ´ i ρ (1 + r)2 (1 − r)2 v 4 + 2r 1 − ρ2 ³ ´ 1 − r 2 v 2 ε2 (A6) + 1 − ρ2 (r (1 − rρ) + (r − ρ)) ε4 .e. 46 . This implies that the correlation in the cash ﬂows of ﬁrms j and k is r. calculate ˜k |Zj .. the standard deviations in their respective cash ﬂows and disclosure errors are identical (i. C = vur. V V i h ˜j . and c = εφρ. It is a straightforward exercise to show that the sign of sign of the expression ∂ Cov ∂ε h ˜k |Zj . if the unconditional covariance in cash ﬂows is non-negative (i. ρ.e. (A6) is determined by the sign of the correlation in disclosure errors.ε=φ . calculate h i ∂ ˜j .where V = v2 . and the magnitude of the former is no less than that of the latter. Thus. The sign of the ﬁrst term in eqn. is ρ. Zk and ˜j . Zk |v=u. f = φ2 .

[1 − A1 (Q)] V ar Vj + [1 − A1 (Q)] Cov Vj . Proof of Proposition 3. Zk |v=u. then the conditional covariance in cash ﬂows moves closer to 0 as the error in ﬁrm j ’s disclosure about its cash ﬂow decreases (i. then the correlations in cash ﬂows and disclosure errors do not have opposite signs. the conditional covariance in cash ﬂows moves closer to 0 as the error in ﬁrm j ’s disclosures about its cash ﬂow decreases. ≈ H (Q) = 1 PJ ˜ ˜j . Thus. V V i the sign of the unconditional covariance in cash ﬂows.E. C = vur < 0. H (Q) can be expressed as ˜j |Q ˜j∗ − A0 (Q) (1 − A1 (Q)) E V E V h i h i. ⎣ Cov Vj .e. i.e. Similarly.ε=φ decreases ˜j .ε=φ increases as ε decreases). thus. With a large number of ﬁrms. in the special case of uncorrelated disclosure errors. ∂ Cov ∂ε h ˜k |Zj . ρ = 0..e. V ˜k |Zj .D. note that when disclosure errors are uncorrelated. if the unconditional covariance in cash ﬂows is negative (i. | Q k 1 j k k=1 k6=j Nτ 47 h i h i . and the magnitude of the former is no less than that of the latter. E V and J J h i X X 1 1 ⎝ 2 ∗ ˜ ˜ ˜ ˜k |Q⎦⎠ .e. ∂ Cov ∂ε as ε decreases). where A1 (Q) is between 0 and 1. the conditional covariance in cash ﬂows moves closer to 0 as the error in ﬁrm j ’s disclosures about its cash ﬂow decreases. The expected value and covariance of the net amount received by the ﬁrm’s shareholders are ˜j |Q = (1 − A1 (Q)) E V ˜j∗ − A0 (Q) . Finally. Q.. Vk |Q = V Nτ N τ k=1 k6=j h ˜j . irrespective of V i h i h i " # ⎛ ⎡ ⎤⎞ respectively. PJ ˜ ˜ V V V V Cov | Q (1 − A ( Q )) Cov . Zk |v=u. the ﬁrm-variance eﬀect is small. Thus. which requires r < 0)..then the conditional covariance in cash ﬂows moves closer to 0 as the error in ﬁrm j ’s disclosure about its cash ﬂow decreases (i..

D. respectively. PJ ˜ E V | Φ | V k k=1 h i Nτ ∂H ∂Q h i h i = 0. ´ − Rf µ + 1 σ Nτ ³ ´2 1 σ Nτ ´³ µ0 − 1 Nτ ´ µ− 1 σ Nτ ´2 48 . provided that A0 (Q) is nonnegative and C ∗ > 0 we have ∂H ≥ 0. J V ˜ |Φ|] ∂ Cov[V k=1 k h ˜j |Φ| . Then ∂H (−A01 (Q) E ∗ − A00 (Q)) (1 − A1 (Q)) C ∗ − ([1 − A1 (Q)] E ∗ − A0 (Q)) (−A01 (Q) C ∗ ) = ∂Q ([1 − A1 (Q)] C ∗ )2 −A00 (Q) (1 − A1 (Q)) C ∗ − A0 (Q) A01 (Q) C ∗ = ([1 − A1 (Q)] C ∗ )2 −A00 (Q) (1 − A1 (Q)) − A0 (Q) A01 (Q) = . h i h i 0 ˜j . 1 µ − Nτ σ In addition. Q. (1 − A1 (Q))2 C ∗ Noting that A00 (Q) and A01 (Q) are both non-positive. E Rj |Φ = ˜j |Φ| − 1 Cov V ˜j . ∂ h˜ i E Rj |Φ = ∂σ ³ Rf µ0 + 1 1 Nτ ´³ µ− 1 σ Nτ = − Nτ (σ µ0 − µ) (Rf + 1) ³ ³ µ− . and µ = ˜ j |Φ to be deﬁned as This allows E R h h h i i h i ∂ P E ˜j .˜j∗ and Cov V ˜j . and if A0 (Q) = A00 (Q) = 0 then from Lemma 1 the cost of capital is decreasing in H (Q). µ = E Vj |Φ| .E. ∂Q if C ∗ < 0 the reverse result holds. V i 1 i Rf µ + N σ τ ˜ E Rj |Φ = . Finally. PJ ˜ Next. Cost of capital is deﬁned as ˜j |Φ| + 1 Cov V ˜j . Proof of Proposition 4. for convenience let E ∗ and C ∗ represent E V k6=j Vk |Q . PJ ˜ ˜ Let σ = Cov V k=1 Vk |Φ| . PJ ˜ Rf E V k=1 Vk |Φ| Nτ ˜ h i h i .

In other words. provided that µ0 < µ . σ i ˜ j |Φ .E.D. h i 49 . a decrease in σ implies a decrease in E R σ Q.This implies that provided that ∂ E ∂σ h ˜ j |Φ assumes the same sign as the sign of the change in σ R µ0 < µ .

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