The Information Environment and Cost of Capital

In empirical tests guided by recent theory (e.g., Hughes, Liu and Liu 2007; and Lambert, Leuz and Verrecchia 2011), we examine the joint effects of information precision, information asymmetry and the level of market competition on firms' cost of equity capital. Consistent with theory, we find that average information precision and the level of market competition reduce the positive effect of information asymmetry but do not eliminate it. Besides examining various aspects of the environment jointly, our study is also unique in that we follow the suggestions of Sheng and Thevenot (2012) for modifying the Barron, Kim, Lim and Stevens (1998) measures of information asymmetry and precision. We find that cost of equity capital varies greatly with the modified measures of information asymmetry and average information precision. For example, our regression estimates suggest that information asymmetry and average information precision are more important than equity beta and firm size in determining firms' cost of capital, and that such a substantial effect from information asymmetry and information precision is not apparent using unmodified BKLS measures