Information environment and the cost of capital

In empirical tests guided by recent theory (e.g., Hughes, Liu and Liu 2007; and Lambert, Leuz and Verrecchia 2012), we examine the joint effects of information asymmetry and information precision on the cost of capital and how these effects vary based on the amount and quality of available information and the level of market competition. Consistent with theory, we find that average information precision is an important factor that may alter the relation between information asymmetry and the cost of capital, leading to erroneous inferences, if not considered. We also show that, while information asymmetry increases the cost of capital in most settings, it decreases the cost of capital when the amount of public information is low, while it has no effect when the total information is of high quality and when there is a high level of market competition. Our final results indicate that the precision of private information decreases the cost of capital when the amount of public information is low, while it increases it when the quality of total information is low. Besides examining various aspects of the environment jointly, our study is also unique in that we use better measures of information asymmetry and precision, which allows us to tease out the economic significance of each factor on cost of capital. We find that cost of equity capital varies greatly with our measures of information asymmetry and average information precision. For example, our regression estimates suggest that information asymmetry and average information precision are comparable in importance to equity beta and firm size in determining firms’ cost of capital.