Firms' Capital Allocation Choices, Information Quality, and the Cost of Capital

26 Pages Posted: 6 Feb 2004

See all articles by Christian Leuz

Christian Leuz

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); Leibniz Institute SAFE; CESifo Research Network; Center for Financial Studies (CFS)

Robert E. Verrecchia

University of Pennsylvania - Accounting Department

Date Written: January 2005

Abstract

In this paper, we establish a link between information quality, firms' capital investment decisions and their cost of capital. We characterize asset prices in a market equilibrium framework with perfect competition for firm shares and derive a pricing equation that is equivalent to the CAPM. Using this characterization, we show that higher information quality leads to a lower cost of capital via its effect on expected cash flows. Better information improves the coordination between firms and investors with respect to capital investment decisions, which investors price in equilibrium by discounting firms' expected cash flows at a higher rate. This effect survives the forces of diversification in a capital market with perfect competition, even when information quality is uncorrelated across firms.

Keywords: Cost of capital, Disclosure, Information risk, Asset pricing, Risk premium

JEL Classification: G12, G14, G31, M41, M45

Suggested Citation

Leuz, Christian and Verrecchia, Robert E., Firms' Capital Allocation Choices, Information Quality, and the Cost of Capital (January 2005). Available at SSRN: https://ssrn.com/abstract=495363 or http://dx.doi.org/10.2139/ssrn.495363

Christian Leuz

University of Chicago - Booth School of Business ( email )

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HOME PAGE: http://faculty.chicagobooth.edu/christian.leuz/

National Bureau of Economic Research (NBER) ( email )

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Centre for Economic Policy Research (CEPR) ( email )

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Leibniz Institute SAFE ( email )

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CESifo Research Network

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Center for Financial Studies (CFS) ( email )

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Robert E. Verrecchia (Contact Author)

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
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215-573-2054 (Fax)

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