Cost of Capital

Information and the Cost of Capital

David Easley Department of Economics Cornell University and Maureen O’Hara Johnson Graduate School of Management Cornell University

November 2001

*We would like to thank Anat Admati, Christopher Gadarowski, Jerry Hass, Soeren Hvidkjaer, Eugene Kandel, Wayne Ferson, Rene Stulz and seminar participants at Columbia, Cornell and Michigan State for helpful comments. The authors can be reached at dae3@cornell.edu and mo19@cornell.edu.

Information and the Cost of Capital Abstract

We investigate the role of information in affecting a firm’s cost of capital. Using a multi-asset rational expectations model, we show that differences in the composition of information between public and private information affect the cost of capital, with investors demanding a higher return to hold stocks with greater private information. This higher return arises because informed investors are better able to shift their portfolio weights to incorporate new information, and uninformed investors are thus disadvantaged. The model demonstrates how in equilibrium the quantity and quality of information affect asset prices, resulting in cross-sectional differences in firms’ required returns. We show how a firm can influence its cost of capital by choosing features like accounting treatments, financial analyst coverage, and market microstructure.

JEL Classification Numbers: G3, G12, D82

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Information and the Cost of Capital 1. Introduction Fundamental to a variety of corporate decisions is a firm’s cost of capital. From determining the hurdle rate for investment projects to influencing the composition of the firm’s capital structure, the cost of capital influences the operations of the firm and its subsequent profitability. Given this importance, it is not surprising that a wide range of policy prescriptions have been advanced to help companies lower this cost. For example, Arthur Levitt, the outgoing chairman of the Securities and Exchange...