19.JAR02-1-Botosan

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Printed in U.S.A.

A Re-examination of Disclosure

Level and the Expected Cost

of Equity Capital

C H R I S T I N E A . B O T O S A N∗ A N D M A R L E N E A . P L U M L E E∗

ABSTRACT

This paper examines the association between the cost of equity capital and

levels of annual report and timely disclosure, and investor relations activities.

We estimate the cost of equity capital using the classic dividend discount model.

We find that the cost of equity capital decreases in the annual report disclosure

level but increases in the level of timely disclosures. The latter result is contrary

to theory but is consistent with managers’ claims that greater timely disclosures

may increase the cost of equity capital, possibly through increased stock price

volatility. We find no association between the cost of equity capital and the level

of investor relations activities. We conclude that aggregating across different

disclosure types results in a loss of information. Failing to include all disclosure

types in regression analyses may lead to a correlated omitted variable bias and

erroneous conclusions.

I. Introduction

This paper explores the association between the expected cost of equity

capital and three types of disclosure (annual report, quarterly and other

∗ University of Utah. The authors would like to thank Professor Shelley Rhoades for her

assistance in using Mathematica and Professor Nicolas Bollen for his assistance with the numer-

ical approximation program. We would also like to thank our anonymous reviewer, Andrew

Christie, Myron Gordon, Neil Bhattacharya, Uri Loewenstein, Jim Ohlson, Taylor Randall and

the workshop participants at the 2000 American Accounting Association Annual Meeting,

Louisiana State University, The Eleventh Annual Conference of Financial Economics and Ac-

counting at the University of Michigan, New York University, University of Notre Dame, and

the University of Utah for their helpful comments and suggestions.

21

Copyright

C , University of Chicago on behalf of the Institute of Professional Accounting, 2002

22 C . A . BOTOSAN AND M. A . PLUMLEE

for Investment Management and Research in their Corporate Information

Committee’s Annual Reviews of Corporate Reporting Practices (AIMR reports).

As expected, we find that the cost of equity capital is decreasing in annual

report disclosure level. The magnitude of the difference in the cost of eq-

uity capital between the firms providing the most annual report disclosure

relative to those providing the least is approximately 0.7 percentage points,

after controlling for market beta and firm size. In contrast to our expec-

tations, however, we find a positive association between the cost of equity

capital and the level of more timely disclosures, such as the quarterly report

to shareholders. We show that the cost of equity capital is approximately

1.3 percentage points higher for firms providing the most quarterly and

other published report disclosure relative to firms providing the least of this

type of disclosure, after controlling for market beta and firm size. This re-

sult, while contrary to that predicted by theory, is consistent with managers’

claims that greater timely disclosure increases the cost of equity capital,

possibly through increased stock price volatility. Finally, we find no associ-

ation between the cost of equity capital and the level of investor relations

activities.

Using annual report disclosures for one industry, within a single year,

Botosan [1997] documents a negative association between the cost of eq-

uity capital and voluntary disclosure level for firms with a low analyst follow-

ing but finds no association between these variables for firms with a high

analyst following. Our results, based on a much larger sample, suggest that

firms with a high analyst following benefit from providing greater annual re-

port disclosure. Moreover, this paper addresses two important questions left

unanswered by Botosan [1997]. Does type of disclosure matter? Our results

suggest that type of disclosure is critical since we document negative, posi-

tive, and no association between disclosure level and the cost of equity cap-

ital depending on disclosure type. Do the results generalize to a sample not

limited to one year [1990] or one industry (machinery)? Our analysis con-

firms and extends the results documented in Botosan [1997] for low analyst

following firms to a sample comprised of large, heavily followed firms rep-

resenting 43 different industries and spanning an eleven-year period from

1986–1996.

A number of recent empirical studies suggest a link between the cost of

equity capital and disclosure. For example, Frankel, McNichols, and Wilson

[1995] find that managers of firms that access the capital markets provide

more frequent management earnings forecasts. Welker [1995] documents

a negative association between disclosure levels and relative bid-ask spreads.

As discussed previously, Botosan [1997] documents a negative association

between the cost of equity capital and disclosure level for firms with a low

analyst following. Healy, Hutton, and Palepu [1999] find that firms that

DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 23

institutional ownership, analyst following, and stock liquidity. Finally, Lang

and Lundholm [2000] conclude that firms that increase their disclosure

level in anticipation of a stock offering experience price increases prior to

the offering.

Each of the studies described in the preceding paragraph relies on two

streams of theoretical research to support the hypothesis that greater dis-

closure is associated with a lower cost of equity capital. The first stream

suggests that greater disclosure enhances stock market liquidity, thereby re-

ducing the cost of equity capital either through reduced transaction costs

or increased demand for a firm’s securities.1 For example, Amihud and

Mendelson [1986] suggest that the cost of equity capital is greater for secu-

rities with wider bid-ask spreads because investors require a higher return to

compensate for added transaction costs. Disclosing information allows firms

to reduce the adverse selection component of the bid-ask spread, thereby

reducing their cost of equity capital. Diamond and Verrecchia [1991] claim

that greater disclosure reduces the amount of information revealed by a

large trade. When the adverse price impact of such a trade is reduced, in-

vestors are willing to take larger positions in a firm’s securities, thereby

increasing the demand for its securities and reducing its cost of equity

capital.

The second stream of research suggests that greater disclosure reduces

the estimation risk associated with investors’ assessments of the parameters

of an asset’s return or payoff distribution.2 These researchers maintain that

investors estimate the parameters of a security’s payoff distribution based

on available information about the firm. Using a Bayesian approach and

realizing that investors form predictive distributions as a function of their

uncertainty about the true parameters, Barry and Brown [1985], Handa

and Linn [1993], and Coles, Loewenstein, and Suay [1995] conclude that

estimation risk (or information risk) is nondiversifiable. They also suggest

that the traditional CAPM formula for market beta does not reflect this

risk, resulting in estimates of market beta that are too low for low infor-

mation securities. To date, there is no consensus in the literature regard-

ing the diversifiability or lack thereof, of estimation risk (Clarkson, et. al

[1996]).

The theoretical and empirical research, discussed above, support the fol-

lowing hypothesis:

Ha : There is a negative association between the cost of equity capital

and disclosure level.

1 See for example, Demsetz [1968], Copeland and Galai [1983], Glosten and Milgrom

[1985], Amihud and Mendelson [1986] and Diamond and Verrecchia [1991].

2 See for example, Klein and Bawa [1976], Barry and Brown [1985], Coles and Loewenstein

[1988], Handa and Linn [1993], Coles, et al. [1995], and Clarkson, et. al. [1996].

24 C . A . BOTOSAN AND M. A . PLUMLEE

Our sample selection begins with the 4,705 firm-year observations in-

cluded in the AIMR Reports dated from 1985/86 through 1995/96.3 We

require Value Line forecasts to calculate our measure of the expected cost

of equity capital, so our sample is limited to firms followed by Value Line.

This reduces our sample by 23% to 3,623 firm-year observations. Even when

Value Line follows a firm, the data necessary to form our cost of equity capital

measure are not always available. Eliminating these observations from the

sample yields a final sample of a maximum of 3,618 firm-year observations.

Table 1 summarizes our sample selection procedures and shows the dis-

tribution of the 3,618 firm-year observations across industries (panel B) and

years (panel C). The number of times a given firm appears in the sample

is provided in panel D. As shown in panel B, the sample is well dispersed

across industries. No one industry contributes greater than 10% of the ob-

servations to the sample except for banking, which accounts for 11.25% of

the total. The sample is fairly evenly distributed across years as well, with

1991 contributing the largest proportion of observations of any single year

(12.05%). Our sample includes 668 individual firms. Of these, 110 firms

(16.47% of the number of firms) appear in our sample in only one year.

However, 72 firms (10.78% of the number of firms) appear in the sample in

all eleven years and contribute 21.89% of the firm-year observations. Since

the same firm can appear multiple times in our data we perform sensitivity

analyses to ensure that our conclusions are not sensitive to the inclusion of

multiple observations per firm.

THE MODEL

We test our hypothesis by regressing the expected cost of equity capital

(r) on market beta (BETA), the natural log of market value (LMVAL), and

fractional disclosure rank (RDSCR).That is,

r it = γ0 + γ1 BETAit + γ2 LMVALit + γ3 RDSCR it + εit . (1)

Using alternative specifications of regression equation (1), we examine

the impact on the cost of equity capital of cross-sectional variation in total

disclosure level and cross-sectional variation in disclosure level by type of

disclosure. The three types of disclosure we examine are those included in

the AIMR Reports: annual report, other publications, and investor relations.

Consequently, in our empirical analysis we replace RDSCR by RTSCR (the

3 Typically, the AIMR produces scores or ranks for each category of disclosure (annual

and other required reports, quarterly reports and other published information and investor

relations) and a total score or rank for each firm within an industry. In some instances, however,

only total scores or ranks are reported. This reduces our overall sample size when category

scores or ranks are used as independent variables.

DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 25

TABLE 1

Sample Selection Procedures

The table below shows the determination of the sample and the distribution of firm-year

observations by industry membership, year and frequency. Industry names and the allocation

of firm-year observations across industries are taken from the Annual Reviews of Corporate

Reporting Practices prepared by the Corporate Information Committee of the Association for

Investment Management and Research.

Total firm-years followed by AIMR 4705 100.0

Total firm-years not followed by Value Line 1082 23.0

Total firm-years with insufficient data 5 0.1

Total firm-year observations 3618 76.9

Observations by industry

Years in

Panel B: Sample breakdown by industry Sample # %

Aerospace 86–91 66 1.82

Airline 86–96 90 2.49

Apparel 86–94 82 2.27

Automotive 96 11 0.30

Banking 86–93 407 11.25

Canadian Banking 94–96 1 0.03

Chemical 87–95 104 2.87

Coal Mining 91–92 6 0.17

Computer and Electrical 89–92 53 1.46

Construction 89–96 52 1.44

Container and Packaging 89–93 42 1.16

Diversified Companies 88–93 49 1.35

Domestic Oil 86–96 98 2.71

Domestic Oil Refining 91–96 24 0.66

Drilling and Oil 86 8 0.22

Electrical Equipment 86–96 100 2.76

Environmental Control 86–96 54 1.49

Financial Services Industries 86–94 98 2.71

Food, Beverage and Tobacco 86–96 209 5.78

Health Care 86–96 180 4.98

Health Care Services 87–88 7 0.19

Independent Oil 88–92 28 0.77

Insurance Sub 86–96 272 7.52

International Oil 86–96 76 2.10

International Pharmaceuticals 92–94 3 0.08

Machinery 86–95 150 4.15

Motor Carrier 86–91 34 0.94

Natural Gas Distributors 86–96 104 2.87

Natural Gas Pipeline 86–95 105 2.90

Nonferrous & Mining 90–92 26 0.72

Oil and Gas Drilling 91–92 44 1.22

Oil Service and Equipment 87–90 14 0.39

Paper and Forest Products 88–96 154 4.26

Precious Metals 91–96 49 1.35

Publishing and Broadcasting 86–96 178 4.92

Railroad 86–96 69 1.91

Retail Trade 86–96 281 7.77

26 C . A . BOTOSAN AND M. A . PLUMLEE

T A B L E 1—Continued

Observations by industry

Years in

Panel B: Sample breakdown by industry Sample # %

Savings Institutions 89–93 19 0.53

Service Oil 86 8 0.22

Software Data 89–93 101 2.79

Specialty Chemicals 86–94 122 3.37

Telecommunications 94 5 0.14

Textiles 86–94 35 0.97

Total firm-year observations 3618 100.00

Observations by year

1986 293 8.10

1987 296 8.18

1988 295 8.15

1989 381 10.53

1990 426 11.78

1991 436 12.05

1992 419 11.58

1993 377 10.42

1994 258 7.13

1995 228 6.30

1996 209 5.78

Total firm-year observations 3618 100.00

Firms Observations

1 110 16.47 110 3.04

2 63 9.43 126 3.48

3 65 9.73 195 5.39

4 69 10.33 276 7.63

5 52 7.78 260 7.18

6 53 7.93 318 8.79

7 42 6.29 294 8.13

8 69 10.33 552 15.26

9 35 5.24 315 8.71

10 38 5.69 380 10.50

11 72 10.78 792 21.89

Total firms and firm-year observations 668 100.00 3618 100.00

of the model. In the alternative specification RDSCR is replaced by three

disclosure measures: RANLSCR (the fractional rank of the annual report

score), ROPBSCR (the fractional rank of the other publication score), and

RINVSCR (the fractional rank of the investor relations score).4

4 For completeness we also examine three specifications of equation (1) in which RDSCR

DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 27

computed based on a within industry/year ranking of the sample data. These

measures are discussed in more detail in the next section of the paper, as is r,

our estimate of the firm’s expected cost of equity capital.

BETA is included in the models to control for systematic risk. We esti-

mate BETA by the market model using a minimum of thirty monthly return

observations over the five-year period ended June 30 of the AIMR Report

publication year with a value-weighted NYSE/AMEX market index return.5

We take data used in the computation of BETA from the 1998 version of the

CRSP tape. Occasionally, sufficient data to compute BETA are not available

on CRSP. In these instances we substitute Value Line’s estimate of market

beta.

LMVAL is included in the analyses because prior research documents a

significant association between market value and both the expected cost of

equity capital and disclosure level. This suggests market value might induce

a correlated omitted variable bias if excluded from the analysis. We use

the natural log of the market value of outstanding common equity as at

December 31 of the year preceding the AIMR Report publication year in our

tests. We obtain market value of common equity from the CRSP tape. In

those instances where market value of common equity is missing on CRSP,

we collect it from the 1998 version of the COMPUSTAT tape.

We limit our control variables to BETA and LMVAL. In comparison,

Gebhardt, Lee, and Swaminathan (GLS) [2001] include eight firm charac-

teristics in their regression of the expected cost of equity capital on various

firm and industry characteristics. While this is appropriate for the research

question addressed in GLS, our purpose, which is ultimately to examine the

association between the expected cost of equity capital and disclosure level,

is clearly different.6

DESCRIPTIVE STATISTICS PERTAINING TO MARKET BETA AND FIRM SIZE

Panel A of table 2 provides descriptive statistics for firm size and market

beta for the sample pooled across years. The data show that the mean (and

median) firm included in the sample is very large. The mean market value

of common equity (MVAL) is $4.97 billion; the median is $1.98 billion.

This is in sharp contrast to the mean and median firm size of the sample

employed in Botosan [1997], $713 million and $209 million, respectively.

Clearly, limiting the analysis to firms included in the AIMR Reports produces

5 AIMR Reports tend to be published in the last quarter of the year. We assume that each

report assesses firms’ disclosure practices during a one-year period ending June 30 of the

publication year. For example, the 1993/94 report was published in November of 1994. We

assume this report evaluates disclosures made by firms during the period July 1, 1993 through

June 30, 1994.

6 The purpose of the GLS study is to describe the cross-sectional relation between expected

cost of equity capital and a survey of firm and industry characteristics found in prior research

to be statistically associated with realized returns. None of the variables examined in GLS is a

measure of disclosure level.

28 C . A . BOTOSAN AND M. A . PLUMLEE

TABLE 2

Descriptive Statistics During the Period 1986–1996 for Both Pooled Sample and Year-by-Year

The table below provides descriptive statistics for the sample pooled across the sample pe-

riod 1986–1996 and on an annual basis. Our data set includes 3,618 total disclosure ranks

but only 3,463 total disclosure scores since only rank data are provided for some industries.

The number of observations with category disclosure scores is less than 3,463 because some

industry subcommittees do not breakdown the total disclosure score by disclosure category.

The number of disclosure scores for the investor relation category slightly exceeds the num-

ber of disclosure scores for the annual report and other publications categories because the

Oil Service and Drilling Industry Subcommittee did not disclose annual report and other

publication scores in 1987. MVAL is the market value of common equity on December 31st

of the year prior to the publication year of the A IMR Report. BETA is estimated via the mar-

ket model using a minimum of 30 monthly returns over the 60 months prior to June of the

publication year of the A IMR Report. We estimate the market model with a value weighted

NYSE/AMEX market index return. DANLSCR (DOPBSCR, DINVSCR, DTSCR) is the indus-

try/year mean-differenced annual report (other publications, investor relation, total) score.

The mean-differenced disclosure scores are computed by subtracting the industry/year av-

erage score for a given disclosure category from the firm’s score. We convert this into a

percentage figure by dividing the difference by the proportion of total points allocated to the

given category and multiplying the result by one hundred. The resulting figure is the number

of percentage points by which a given firm’s score deviates from the industry mean score for

a given year. rDIV is the estimated cost of equity capital derived from the dividend discount

formula.

Panel A: Pooled sample

Variable MVAL BETA DANLSCR DOPBSCR DINVSCR DTSCR rDIV

n 3618 3618 2419 2419 2433 3463 3618

Mean 4967.7 1.106 0.000 0.000 0.000 0.000 0.165

Percentiles:

1% 83.2 0.237 −23.706 −30.227 −35.686 −30.126 0.024

25% 795.5 0.888 −5.127 −6.480 −6.833 −5.448 0.120

50% 1976.0 1.101 0.464 0.833 1.418 1.039 0.156

75% 4747.4 1.314 5.520 7.333 8.565 6.364 0.202

99% 54484.0 2.131 19.950 23.793 24.882 20.365 0.393

Std. Dev. 9690.2 0.373 8.723 11.306 12.670 9.947 0.073

Panel B: Year-by-year results

Year MVAL BETA DANLSCR DOPBSCR DINVSCR DTSCR rDIV

1986 2667.4 1.068 0 0 0 0 0.144

1168.9 1.061 1.132 0.902 1.619 0.983 0.141

293 293 190 190 190 285 293

1987 3069.2 1.087 0 0 0 0 0.128

1449.4 1.086 0.185 1.667 1.685 1.078 0.129

296 296 199 199 214 296 296

1988 3286.6 1.088 0 0 0 0 0.190

1695.4 1.059 −0.029 0.833 1.288 0.217 0.188

295 295 213 213 213 295 295

1989 3296.8 1.120 0 0 0 0 0.160

1514.6 1.118 0.476 1.235 1.360 1.200 0.154

381 381 252 252 251 365 381

1990 4267.1 1.122 0 0 0 0 0.220

1947.4 1.107 0.569 1.065 1.005 0.850 0.208

426 426 298 298 298 405 426

DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 29

T A B L E 2—Continued

Panel B: Year-by-year results

Year MVAL BETA DANLSCR DOPBSCR DINVSCR DTSCR rDIV

1991 4037.4 1.149 0 0 0 0 0.176

1571.0 1.136 0.204 0.236 0 0.841 0.164

436 436 263 263 263 393 436

1992 5465.1 1.124 0 0 0 0 0.176

2052.2 1.128 0.387 0 1.998 1.229 0.166

419 419 256 256 256 373 419

1993 5993.7 1.169 0 0 0 0 0.148

2758.3 1.192 0.759 0.938 2.187 1.385 0.145

377 377 245 245 245 356 377

1994 7254.6 1.089 0 0 0 0 0.162

3215.9 1.098 0.143 0.781 1.849 0.828 0.160

258 258 193 193 193 258 258

1995 8048.2 1.038 0 0 0 0 0.134

3341.9 1.059 0.464 1.782 2.106 1.172 0.132

228 228 164 164 164 228 228

1996 10637.0 1.004 0 0 0 0 0.127

3879.9 0.945 1.107 0.624 0.826 0.279 0.126

209 209 146 146 146 209 209

analysts.7

Panel B provides similar information to panel A but on a year-by-year

basis. The average (median) sample firm’s market value of common eq-

uity was $2.67 ($1.17) billion in 1986. By 1996 this had grown to $10.64

($3.88) billion. Mean year-by-year BETA’s are comparable to their corre-

sponding medians. Mean BETA increases virtually monotonically during

the first eight years of the sample period, peaking in 1993 at 1.169, followed

by a monotonic decline to 1.004 during the last three years of the period.

DISCLOSURE DATA

Our disclosure data are drawn from the 1985/86–1995/96 AIMR Reports.

The stated goal of the AIMR Reports is to “improve corporate communica-

tions between the investment community and the management of publicly

owned corporations in the United States and elsewhere” [1995/96 AIMR

Report, p. 1]. Each year the AIMR selects a number of industries for con-

sideration and forms industry subcommittees responsible for assessing the

adequacy of the corporate reporting practices of firms within the industry.

The subcommittees use a checklist drawn from guidelines provided by the

AIMR to evaluate companies within their industries. The guidelines suggest

three categories of disclosure be evaluated: (1) annual published and other

7 Lang and Lundholm [1996] show that the number of analysts following the average AIMR

firm during 1985 through 1989 is 17.6. In contrast, the number of analysts following the average

firm in Botosan’s low analyst following sub-sample is 4.8 analysts.

30 C . A . BOTOSAN AND M. A . PLUMLEE

required, and (3) other aspects. The suggested weights applied to each

category in arriving at the total score are 40–50%, 30–40%, and 20–30%.

It can be inferred from these suggested weights that the annual report is

viewed as a particularly important document.

“The annual published and other required information” category con-

siders the clarity and completeness of the annual report (including the

financial statements and footnotes) and required published information

such as 10-Ks and 10-Qs. “The quarterly and other published information

not required” category is concerned with the depth, clarity, and timeliness

of the quarterly report to shareholders, proxy statements, annual meet-

ing reports, fact books, press releases, and newsletters. Finally, access to

management through presentations to analysts, company-sponsored field

trips, and interviews is the focus of the “other aspects” category.

While the guidelines provided to the subcommittees are fairly detailed

and extensive, the subcommittees often deviate substantially from them and

develop disclosure indices tailored to the unique characteristics of their

industries. We convert the AIMR disclosure scores to within industry/year

fractional disclosure ranks, defined as the rank of a given firm’s disclosure

score divided by the number of observations having nonmissing values of

the ranking variable. We rank firms in ascending order, such that firms

providing higher levels of disclosure receive higher ranks. As a result, if

greater disclosure results in a lower cost of equity capital, the coefficient on

the disclosure rank will be negative.

DESCRIPTIVE STATISTICS PERTAINING TO THE DISCLOSURE DATA

Table 2 presents descriptive statistics for the disclosure data. Panel A pro-

vides information pertaining to the pooled sample while panel B gives year-

by-year statistics. This table presents industry mean-differenced disclosure

scores as opposed to disclosure ranks because scores provide a better sense

of the cross-sectional distribution of the disclosure measures.8 The industry

mean-differenced disclosure scores presented in this table are computed by

subtracting the industry/year average score for a given disclosure category

from a given firm’s score. We convert this into a percentage figure by divid-

ing the difference by the proportion of total points allocated to the given

category and multiplying the result by one hundred. The resulting figure is

the number of percentage points by which a given firm’s score deviates from

the industry mean score for a given year. The overall and year-by-year aver-

age mean-differenced scores are all zero due to this procedure. However,

the distribution of the three category mean-differenced scores (DANLSCR,

8 There are fewer than 3,618 observations for DTSCR because only rank data are available

in some industries. As a result these observations are not included in the computations based

on scores, however, they are included in subsequent analysis based on ranks. In addition, the

number of observations by disclosure category is always less than the number of observations in

the total disclosure category because some industry subcommittees do not generate category

scores.

DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 31

indicate variation in disclosure levels. For example, at the 75th percentile

the total disclosure score is 6.364 percentage points greater than the indus-

try average for the given year. At the 25th percentile the total disclosure

score is 5.448 points lower than the corresponding industry/year average.

Depending on the disclosure measure, the inter-quartile range is between

11 and 15 percentage points.

THE COST OF EQUITY CAPITAL

We estimate the cost of equity capital (denoted below as rDIV ) for each

firm-year using the short horizon form of the classic dividend discount

model given in equation (2), below.9

4

Pt = (1 + r )−τ E t [dt+τ ] + (1 + r )−4 P4 (2)

τ =1

r = the expected cost of equity capital

E t (o) = the expectations operator

dt = dividends per share for year t

long-range dividend forecast and maximum and minimum future price esti-

mates from forecasts published by Value Line during the third quarter of the

AIMR Report publication year. Since Value Line does not provide a dividend

forecast for t + 3, we interpolate between the t + 2 and long-range dividend

forecasts to obtain an estimated forecast of dividends for t + 3. We compute

the forecast of price in year T = 4 (P4 ) by taking the mean of the minimum

and maximum long-run price forecasts provided by Value Line.10

We take the current stock price (Pt ) from CRSP on the Value Line publica-

tion date or the closest date thereafter within three days of publication. We

substitute Value Line’s “recent price” for price when price data is not available

on the CRSP tape. In addition, we compare all CRSP price data to Value Line’s

recent price data to identify potential problems arising from stock splits or

stock dividends. If the difference between the CRSP price andValue Line’s

recent price is greater than 15%, we substitute Value Line’s recent price for

the CRSP price.

9 Although Botosan [1997] derives her estimates from the Edwards-Bell-Ohlson (EBO)

valuation model, the estimates produced by these two approaches should be identical barring

any violations of the clean-surplus relation (Lundholm and O’Keefe [2001]). It is not surprising

then that the Spearman rank-order correlation between the estimates is 0.90 (Botosan and

Plumlee [2001]). Since the estimates produced by the dividend discount formula are invariant

to violations of the clean-surplus relation, we employ the estimates produced by this model.

However, all results hold if the cost of equity capital estimates derived from the EBO valuation

model are used instead.

10 Alternatively the price implicit in Value Line’s long-range P/E ratio could be used. As

32 C . A . BOTOSAN AND M. A . PLUMLEE

CAPITAL ESTIMATES

Table 2, panel A provides descriptive statistics pertaining to our cost of eq-

uity capital estimates for the pooled sample. The mean (median) expected

cost of equity capital (i.e. rDIV ) is 16.5% (15.6%). The standard deviation of

the estimates is 7.3%, with an interquartile range of 8.2%. Table 2, panel B

gives year-by-year mean and median data for our expected cost of equity

capital estimates. The estimates suggest an upward trend in the mean cost

of equity capital during the latter part of the 1980s (peaking in 1990 at 22%),

followed by a downward trend during the first half of the 1990s.

V. Empirical Results

UNIVARIATE ANALYSIS OF THE ASSOCIATION BETWEEN THE COST

OF EQUITY CAPITAL AND DISCLOSURE LEVEL

Table 3 presents the average of the year-by-year Spearman correlation

coefficients among rDIV , BETA, LMVAL, and the fractional ranks of each

of our four measures of disclosure (i.e., total, annual, other publications,

and investor relations ranks (RTSCR, RANLSCR, ROPBSCR, and RINVSCR,

respectively). Results using Pearson correlations are substantively similar.

A valid measure of the cost of equity capital should be increasing in risk

as measured by market beta and we find a significant positive association

between BETA and rDIV . The mean correlation coefficient is 0.182 and is

significantly different from zero in ten out of eleven years. In addition to

being positively correlated with BETA, the cost of equity capital estimates

should display the well known “size effect.” Consistent with this expectation,

the results documented in table 3 indicate a negative association between

firm size and rDIV . The mean correlation coefficient is −0.073 and is signifi-

cantly negative in six years and significantly positive in one year.11 Table 3

also documents a strong positive association between firm size and each

of the disclosure measures. This finding agrees with prior research (Lang

and Lundholm [1993]). Contrary to our expectation, however, none of

the disclosure measures is consistently negatively correlated with rDIV . This

analysis ignores the potential impact of correlations among the explanatory

variables, however. In the next section of the paper we perform multivariate

analysis to address this issue.

11 We also explore the joint relationship between the cost of equity capital estimates and

BETA and LMVAL using regression analysis. These results are not presented in a table. How-

ever, we find results consistent with our univariate analysis: cost of equity capital is increasing

(decreasing) in market beta (firm size). The magnitude of the coefficient on BETA, an estimate

of the market risk premium on beta, is in the neighborhood of 3%. Based on these tests, we

conclude that our estimates of cost equity capital are associated with traditional measures of

risk in a manner that supports our claim that these estimates are a valid proxy for expected

cost of equity capital.

DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 33

TABLE 3

Correlation Coefficients Between Cost of Equity Capital, Beta, Log of Market Value,

and Disclosure Measures

The table below provides Spearman correlation coefficients. Analysis employing total disclo-

sure ranks are based on 3,618 observations or an average of 329 observations per year. Analysis

employing annual disclosure ranks and other publication ranks are based on 2,706 observa-

tions, or an average of 246 observations per year. Analysis employing investor relations ranks

are based on 2,728 observations, or an average of 248 observations per year. The number of

observations with category disclosure ranks is less than 3,618 because some industry subcom-

mittees do not breakdown the total disclosure rank by disclosure category. The number of

disclosure ranks for the investor relation category slightly exceeds the number of disclosure

ranks for the annual report and other publications categories because the Oil Service and

Drilling Industry Subcommittee did not disclose annual report and other publication ranks

in 1987. Each cell provides the average yearly correlation coefficient; the number of years out

of the eleven-year sample period the correlation coefficient is significantly positive/negative

with a p-value less than 0.10 (in parentheses); and the average number of observations per

year. rDIV is the estimated cost of equity capital derived from the dividend discount formula.

BETA is estimated via the market model using a minimum of 30 monthly returns over the

60 months prior to June of the publication year of the AIMR Report. We estimate the market

model with a value weighted NYSE/AMEX market index return. LMVAL is the natural log of

the market value of common equity on December 31st of the year prior to the publication year

of the AIMR Report. RTSCR (RANLSCR, ROPBSCR, RINVSCR ) is the rank of the total (annual

report, other publications, investor relation) score.

0.182

BETA (10/0) —

329

−0.073 −0.030

LMVAL (1/6) (0/2) —

329 329

0.0002 0.042 0.208

RTSCR (0/1) (1/0) (11/0) —

329 329 329

0.008 0.018 0.185 0.824

RANLSCR (0/1) (0/0) (11/0) (11/0) —

246 246 246 246

0.021 0.050 0.136 0.791 0.634

ROPBSCR (0/0) (1/0) (7/0) (11/0) (11/0)

246 246 246 246 246 —

0.003 0.020 0.180 0.743 0.499 0.495

RINVSCR (0/3) (0/0) (11/0) (11/0) (11/0) (11/0)

248 248 248 248 246 246

OF EQUITY CAPITAL AND DISCLOSURE LEVEL

employ different combinations of the disclosure measures as explanatory

variables. We report the average coefficient obtained from estimating the

regression equations year-by-year and Fama and MacBeth t-statistics for all

34

TABLE 4

OLS Regressions of the Cost of Equity Capital on Beta, Log of Market Value, and Disclosure Rank

The table below provides the average yearly parameter estimates obtained in cross-sectional regressions for years 1986–1996 and Fama and MacBeth [1973]

intertemporal t-statistics. Model 1 includes the rank of the total disclosure score and is estimated with an average of 329 observations per year (i.e. a total 3,618

observations across the eleven-year period). Model 2 includes the ranks of all three of the individual disclosure categories that comprise the total disclosure

score and is estimated with an average of 246 observations per year (i.e. a total 2,706 observations across the eleven-year period). Models 3–5 include each of

the three types of disclosure individually in turn (annual report, other publications, and investor relations). Model 3 and 4 are estimated with an average of

246 observations per year (i.e. a total 2,706 observations across the eleven-year period). Model 5 is estimated with an average of 248 observations per year (i.e.

a total 2,728 observations across the eleven-year period). The number of observations with category disclosure ranks is less than 3,618 because some industry

subcommittees do not breakdown the total disclosure rank by disclosure category. The number of disclosure ranks for the investor relation category slightly

exceeds the number of disclosure ranks for the annual report and other publications categories because the Oil Service and Drilling Industry Subcommittee

did not disclose annual report and other publication ranks in 1987. BETA is estimated via the market model using a minimum of 30 monthly returns over

the 60 months prior to June of the publication year of the AIMR Report. We estimate the market model with a value weighted NYSE/AMEX market index

return. LMVAL is the natural log of the market value of common equity on December 31st of the year prior to the publication year of the AIMR Report. RTSCR

(RANLSCR, ROPBSCR, RINVSCR) is the rank of the total (annual report, other publications, investor relation) score. Sample size varies across models because

disclosure category ranks (i.e. RANLSCR, ROPBSCR, RINVSCR) are missing for some industries. *, **, *** indicate significant at a p-value of less than 0.10, 0.05

and 0.01, respectively, using a one-tailed test of significance. # indicates more than two standard deviations from zero.

Model 1 Model 2 Model 3 Model 4 Model 5

Expected

Sign Coeff t-Stat Coeff t-Stat Coeff t-Stat Coeff t-Stat Coeff t-Stat

Intercept NA 0.216 8.10 0.188 5.74 0.189 5.71 0.189 5.71 0.187 5.60

BETA + 0.030 5.69∗∗∗ 0.034 5.54∗∗∗ 0.034 5.51∗∗∗ 0.034 5.56∗∗∗ 0.034 5.53∗∗∗

LMVAL − −0.006 −3.73∗∗∗ −0.005 −2.36∗∗ −0.005 −2.26∗∗ −0.005 −2.37∗∗ −0.005 −2.30∗∗

RTSCR − 0.003 0.74

RANLSCR − −0.007 −1.95∗∗ 0.000 0.001

ROPBSCR − 0.013 2.46# 0.008 2.42#

RINVSCR − −0.001 −0.16 0.002 0.48

Average N 329 246 246 246 248

Avg. Adj. R2 5.11% 6.26% 6.08% 6.26% 6.39%

DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 35

and its magnitude suggests a market risk premium in the neighborhood of

3.4%. The coefficient on LMVAL is significantly negative in all 5 models and

the coefficient on LMVAL indicates that a one unit increase in firm size as

measured by log of market value is associated with approximately a one-half

percentage point decrease in the cost of equity capital. The direction of

the association between rDIV and BETA and LMVAL is consistent with the

univariate results reported earlier.

Model 1 in table 4 reports the results estimating regression equation (1),

with RDSCR replaced by a measure of total disclosure level (RTSCR). The

coefficient on total disclosure (RTSCR) is not statistically different from

zero. This result is at odds with our expectations and theory, which suggests

that greater disclosure is associated with a lower cost of equity capital. Em-

ploying total disclosure level in the analysis, however, fails to allow for the

possibility that the association between the cost of equity capital and disclo-

sure may vary across different types of disclosure. This possibility is explored

in model 2, which replaces the RDSCR variable in regression equation (1)

with the 3 separate disclosure category ranks (RANLSCR, ROPBSCR, and

RINVSCR).

The results of estimating model 2 show that the sign of the coefficient on

disclosure is indeed a function of disclosure type. The coefficient on annual

report score (RANLSCR) is significantly negative, suggesting that greater

annual report disclosure is associated with a lower cost of equity capital after

controlling for firm size and market beta. This result is stable across years.

The coefficient on RANLSCR is negative in 9 of the 11 years in our sample

period and is consistent with the annual report being an important source

of information to analysts and other investors. This extends the finding in

prior literature of a negative association between disclosure level and the

cost of equity capital for firms with low analyst following to larger, more

heavily followed firms, across a diverse group of industries, over a number

of years.

While greater annual report disclosure is associated with a lower cost of

equity capital, the coefficient on the other publications score (ROPBSCR)

is not significantly negative. To the contrary, the analysis yields a positive co-

efficient on ROPBSCR that is more than two standard deviations from zero

12 The results of a regression pooled across all eleven years and adjusted t-statistics using

Froot’s [1989] procedure provides substantively similar results. Froot’s procedure uses the

residuals from the OLS regression to estimate a nonzero cross-time covariance for each sample

firm. We also use the procedure employed in Abarbanell and Bernard [2000] to adjust the

Fama-Macbeth t-statistics reported in the table. Results using this method are also substantively

similar to those presented in the tables. The Abarbanell-Bernard procedure adjusts the stan-

dard errors used in the Fama-Macbeth calculations for serial correlation in the coefficient

estimates produced by year-by-year regressions. In our data, the time-series coefficients used

in the adjustment are not statistically significant (expect one model, where the coefficient on

RINVSCR was significantly positive), suggesting that time-series correlation in the coefficients

is not a significant concern in this case.

36 C . A . BOTOSAN AND M. A . PLUMLEE

ciated with a higher cost of equity capital. This result is also stable across

years, with the coefficient on ROPBSCR positive in 9 out of 11 years. In

the next section of the paper, we provide some additional discussion and

interpretation of this unexpected result. Finally, we find no association be-

tween investor relation disclosure level and the cost of equity capital. Using

the category ranks instead of the total disclosure ranks increases the overall

explanatory power of the regressions from 5.11% in model 1 to 6.26% in

model 2, an increase in the adjusted R2 of approximately 22%.

As noted earlier, our three types of disclosure are correlated with each

other. The lowest correlation of 0.495 is between the other publications and

investor relations ranks whereas the highest correlation, 0.634 is between the

annual report and other publications ranks. The correlation among the dis-

closure variables is a double-edged sword. It may induce multi-collinearity,

which may weaken the power of the tests but should not yield a coefficient

with the “incorrect” sign. However, failing to adequately control for other

types of disclosure when evaluating the impact of an alternative disclosure

type on the cost of equity capital may lead to spurious correlation and erro-

neous conclusions.

To examine this issue, we replace RDSCR in regression equation (1) with

each of the three disclosure category variables in separate models. Model 3

employs RANLSCR, model 4 incorporates ROPBSCR, and model 5 uses

RINVSCR as the independent variable measuring disclosure level. The re-

sults of this analysis highlight the importance of adequately controlling for

alternative means of disclosure when examining the association between

disclosure level and the cost of equity capital. For example, the results of

model 3 taken in isolation would suggest that annual report disclosure level

and the cost of equity capital are not related, while the results of model 4

continue to produce a coefficient on ROBSCR that is positive and more than

two standard deviations from zero. The strength of the association between

ROBSCR and cost of equity capital combined with the strong positive corre-

lation between RANLSCR and ROBSCR is apparently sufficient to cause a

severe correlated omitted variables bias in model 3. Consequently, not con-

trolling for ROPBSCR when assessing the association between RANLSCR

and the cost of equity capital leads the researcher to an erroneous conclu-

sion regarding the impact of annual report disclosure level on cost of equity

capital.

PUBLICATIONS DISCLOSURE

Our finding that greater disclosure in the other publication category is

statistically associated with a higher cost of equity capital is contrary to the

disclosure theory discussed earlier and our hypothesis. However, this finding

is consistent with concerns expressed by financial executives and others

about the effect of timely disclosures (such as quarterly reports, a major

component of this disclosure category) on the cost of equity capital through

DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 37

stock price volatility. For example, The Financial Times (Iskander [May 7,

1999]) reports that

“The French business community is divided on the benefits of quarterly

disclosure. A large number of managers . . . believe the move would foster

short-termism among investors and increase the volatility of share prices (emphasis

added).”

congressman from Pennsylvania, to introduce a bill in 1992 to revoke the

Securities and Exchange Commission’s authority to require quarterly re-

porting. Congressman Ritter justified the move by claiming it was a means

of reducing pressure on firms to focus on short-term profits over long-term

shareholder value (Ritter [1992]).

Results documented in Bushee and Noe (BN) [2000] also provide ev-

idence consistent with this story. Using AIMR total disclosure scores, BN

find that higher overall disclosure quality tends to reduce future stock re-

turn volatility, by attracting long-term investors to the firm. They also find,

however, that a high level of disclosure can have a detrimental effect, as it also

attracts transient institutions that trade aggressively on short-term earnings

news. They conclude that the volatility-reducing effect of the trading activity

of long-term investors is almost completely offset by the volatility-increasing

effect arising from the trading activities of transient institutional investors.

While BN’s primary reported results are based on total disclosure scores,

they also examine the association between type of institutional investor and

the three categories of disclosure. In footnoted results (BN, page 15) BN

document a significant positive association between the level of transient

institutional investor ownership and the quality of more timely disclosures

and investor relations but not annual report disclosure. These results indi-

cate an institutional investor clientele effect that is a function of the quality

of disclosure in a given category. Moreover, it supports the supposition that

providing greater timely disclosure attracts a greater proportion of transient

institutional investors whose trading activities have a volatility-increasing ef-

fect on stock returns.

SENSITIVITY ANALYSIS

All of our primary analyses are based on the ranks of the disclosure mea-

sures as opposed to the scores themselves, because the AIMR disclosure

scores are an ordinal measure of disclosure level. In contrast, rDIV , BETA,

and LMVAL are cardinal measures and are included in the models in un-

ranked form to take full advantage of the variation in these measures across

firms. We assess the sensitivity of our results to these choices by estimating a

fully ranked specification of model 2, wherein the fractional rank of rDIV is

regressed on the fractional ranks of each of BETA, LMVAL, and the three

measures of disclosure (RANLSCR, ROPBSCR, and RINVSCR).

The results of this analysis differ from those presented in table 4 in two

respects. First, the explanatory power of the rank model is much lower.

The R2 produced by the rank regression is half as large as that reported in

38 C . A . BOTOSAN AND M. A . PLUMLEE

regression, it is no longer statistically significant.13

It is important to note that ranking the data limits the informativeness of

the measures included in the regression. In addition, the interpretation of

the magnitude of the coefficients is lost. Rank regressions are appropriate

when the values of the measures are uninformative in and of themselves but

act primarily to order the data (this is the case with the disclosure measures),

or when outliers are a significant concern, or when the distribution of the

variables is not normal or is unknown. Since cross-firm variation in rDIV ,

BETA, and LMVAL is potentially informative and the other problems are

not a significant concern, we believe the loss of statistical significance and

reduction in explanatory power discussed in the preceding paragraph are

consistent with a loss of information.

In additional sensitivity analyses, we include in our analysis two variables

with a prior documented association with the cost of equity capital. The

variables are book-to-market (B/M) (measured as the log of book value

divided by stock price) and price momentum (PrMOM) (measured as the

stock’s return from January through June of the same year for which our

other variables are measured).14

Fama and French [1992] document that high B/M firms earn higher ex-

post realized returns than low B/M firms. In addition, Gebhardt, Lee, and

Swaminathan [2001] find that B/M is positively related to their estimate

of expected cost of equity capital. Jegadeesh and Titman [1993] examine

PrMOM and find that past winners (based on returns over the past 3 to

12 months) earn substantially higher returns than past losers. Although

prior research has documented statistical associations between these vari-

ables and the cost of equity capital as measured by realized returns or an

estimate of the expected cost of equity capital, it has not provided a theory-

based explanation for these findings.

We do not include either variable in our primary analysis because of this

lack of a theoretical underpinning and because neither variable is correlated

with disclosure level. As a result, it is unlikely that omitting B/M and PrMOM

from regression equation (1) induces a correlated omitted variable bias with

respect to our disclosure measures.

The results of estimating such a regression equation show that even after

controlling for B/M and PrMOM in addition to BETA and LMVAL the

conclusions drawn from model 2 are unaffected. That is, the cost of equity

capital is negatively associated with RANLSCR, positively associated with

ROPBSCR and not associated with RINVSCR. Consistent with prior research,

13 We also estimated the additional models included in table 4 using ranks instead of the

cardinal measures. The results using ranks in these models were similar to those found when

using ranks for model 2. The explanatory power of the rank models are much lower, and the

coefficients on variables of interest have the same sign as the regressions based on cardinal

measures, though they are not always statistically significant.

14 These measures as formed consistent with variables found in Gebhardt, Lee, and

Swaminathan[2001].

DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 39

As including these measures increases the overall explanatory power of the

regression to 18.7%, it is clear that each is capturing some aspect of the

expected cost of equity capital not explained by the other variables included

in the model but it does not appear that either captures information risk.

We examine the effect of total disclosure on the cost of equity capital and

find, contrary to our expectations, that greater total disclosure is not asso-

ciated with a lower cost of equity capital. However, we find that limiting the

analysis to an examination of the association between overall disclosure level

and the cost of equity capital is insufficient, as the relation between disclo-

sure level and cost of equity capital varies by type of disclosure. Moreover, we

find that examining the association between one type of disclosure without

controlling for other types of disclosure may lead to spurious associations

resulting in erroneous conclusions.

Our results indicate that managers of firms that provide greater disclosure

in the annual report benefit in terms of a lower cost of equity capital, amount-

ing to about a 0.7 percentage point difference between the most and least

forthcoming firms. However, greater other publications disclosure (which

is more timely in nature) is associated with a higher cost of equity capital.

The estimated magnitude of the effect is a 1.3 percentage point difference

between the most and least forthcoming firms. Finally, we document no

association between the level of investor relations activities and the cost of

equity capital. Interestingly the results of our analysis provide some support

for managers’ claims that greater disclosure of more timely information in-

creases their cost of equity capital, perhaps through greater stock return

volatility. These claims are in sharp contrast to theoretical models of the re-

lation between the cost of equity capital and disclosure and the bulk of the

empirical research to date. Based on the results of our analysis we suggest

that the conflicting conclusions of both practitioners and theory regarding

the effect of disclosure on the cost of equity capital may have merit. However,

future research directed at explaining the source of the positive association

between the expected cost of equity capital and timely disclosure level is

needed.

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