Effects of Corporate Disclosure on a Firm’s Cost of Capital

Table of Contents

1 Introduction
1.1 Rationale for this Thesis
1.2 Academic Objectives
1.3 Setting the Scene
1.4 Outline and Structure

2 Relevance and Components of the Costs of Capital
2.1 Costs of Equity Capital
2.2 Costs of Debt Capital

3 Causal Link between Disclosure and Costs of Capital
3.1 Disclosure in General
3.2 Disclosure to Reduce Costs of Equity
3.2.1 Disclosure to Reduce Estimation Risk
3.2.2 Disclosure to Reduce Transaction Costs
3.3 Disclosure to Reduce Costs of Debt

4 Methodological Measuring Approaches
4.1 Measuring Disclosure
4.2 Measuring Costs of Equity
4.2.1 Measuring Priced Risk
4.2.1.1 Asset Pricing Approach
4.2.1.2 Dividend Discount Approach
4.2.2 Measuring Information Asymmetry
4.2.2.1 Bid-Ask Spread Approach
4.2.2.2 Trading Volume Approach
4.2.2.3 Share Price Volatility Approach
4.3 Measuring Costs of Debt
4.4 Legitimate Aspects of Empirical Studies

5 Empirical Evidence for the Impact of Disclosure on Costs of Capital
5.1 Discussion of Existing Studies
5.1.1 Priced Risk Studies
5.1.2 Information Asymmetry Studies
5.1.3 Hybrid Studies
5.1.4 Focused Studies
5.2 Contradicting Results
5.2.1 Self-Selection Bias
5.2.2 Correlation Issues
5.2.3 Calculation Issues
5.2.4 Good-Practice Level

6 Conclusion
6.1 Further Research
6.2 Discussion

List of References

Glossary

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List of Figures

Fig. 1 Extract of Potential Influences on the Research Field

Fig. 2 Causal Link between Disclosure and Costs of Capital

Fig. 3 Capital and Information Flows in the Market

Fig. 4 Disclosure to Reduce Costs of Equity

Fig. 5 Disclosure to Reduce Estimation Risk

Fig. 6 Disclosure to Increased Market Liquidity

Fig. 7 Disclosure to Increased Demand in Stocks

Fig. 8 Disclosure to Reduce Default Risk

Fig. 9 Overview of Measuring Approaches

Fig. 10 Good-Practice Level of Disclosure

List of Tables

Tab. 1 Types of Risk for Equity Holders

Tab. 2 Benefits of Corporate Borrowing

Tab. 3 Costs and Benefits of Voluntary Disclosure

Tab. 4 Approaches to Measuring the Level of Disclosure

Tab. 5 Approaches and Findings of Existing Empirical Studies

Tab. 6 Contradicting Results of Existing Empirical Studies

Executive Summary

The potential relation of increased levels of corporate disclosure on a firm’s cost of capital remains of great importance, both from a research-focussed and business-oriented point-of-view; however, the existence of methodological drawbacks has led to ever more complex studies, which eventually made the literature vast and confusing for outside readers. The purpose of this thesis was to organise and thereby simplify the different perspectives on a dynamic issue.

It is argued that, in theory, enhanced transparency levels the marketplace by spreading information more equally among investors. Consequently, the information asymmetry component is mitigated, which translates into lower levels of estimation risk, transaction costs and default risk. After all, theoretical studies provided evidence that increased disclosure lowers the costs of capital.

However, since neither of the involved components is directly observable, a myriad of approaches emerged to approximate actual figures. Although most of these proxies follow similar patterns, it is argued that none of the present approaches is free from constraints, which, in turn, affects the reliability of existing empirical studies. Research, after all, still lacks a generally accepted and holistic approach to the present day. In this context, one of the most recent findings provides a new and rather praxis-oriented perspective, by arguing that firms and investors are merely interested in a good-practice level of disclosure.

Regardless of the perspective, an ultimate conclusion has yet to be revealed by the literature and it seems illusory that academics and practitioners agree on one approach in the future. Nevertheless, the contribution of this thesis was merely to structure and simplify the current state of a dynamic issue. The author therefore used easy to understand graphics and tables and linked the findings to related fields of research, where necessary.

Keywords: Costs of Capital, Voluntary Disclosure, Estimation Risk, Information Asymmetry, Good-Practice Level of Disclosure

1 Introduction

The present thesis is set out to discuss the effects of corporate disclosure on a firm’s cost of capital. It is conducted as a compilation of existing literature, both from a theoretical and empirical perspective.

According to Verrecchia, the question as to whether or not disclosure impacts the cost of capital is fundamentally important for accountants and decision makers as it “provides an economic basis for evaluating the costs and benefits of accounting information”.¹ There is, in fact, a vast amount of research in this field of study, with Botosan and Verrecchia being two of the dominant scholars in recent years. Both did some intensive research on the reliability of traditional measuring techniques, given the fact that the empirical evidence of theoretical assumptions has proven to be rather complex.

Commencing with early theoretical attempts in the 1970s and 1980s, numerous empirical studies have now emerged to examine the relationship, with the most recent papers continuously expanding the research scope and considering additional influences, such as auditing and disclosure policies. However, it will be argued that most of the existing papers have increasingly drifted away from the initial purpose of the topic as they eventually revealed unmanageable findings for practitioners. This thesis contributes to the discussion by comparing and evaluating the different approaches, ultimately resulting in a framework that summarises and categorise the respective studies.

1.1 Rationale for this Thesis

Empirical studies have partly failed to prove the negative relation between enhanced levels of disclosure and a decrease in capital costs after facing methodological drawbacks.² The researchers replied with ever more complex calculations and approximations to these drawbacks, which eventually made the literature vast and confusing for outside readers. In particular, the controversial debate about accurate cost of equity calculations indicates that academics have partly lost sight of the genuine added value for businesses in their studies. Hence, there is the need for a simplified and structured overview of the overall topic, since the implications of increased levels of disclosure on a firm’s cost of capital are not only valuable from a scientific perspective but also from a practitioner’s point of view.

Botosan detected this need and published a comprehensive and straightforward paper on “what we know” about the link between disclosure and costs of capital in 2006.³ Almost a decade later, it is the author’s belief that Botosan’s paper should be updated, given the controversial and constantly changing nature of the topic and particularly in light of recent findings.

The contribution of this thesis is therefore not only to organise the bulk of different perspectives on the topic, but also to simplify the respective opinions in a way that they are beneficial for practitioners again. The ultimate objective of this paper is to compare and contrast research-focussed and business-oriented intentions of the issue and how they may link to each other. In fact, both perspectives have been used loosely by scholars throughout the literature.

1.2 Academic Objectives

The aim of this thesis is to thoroughly discuss the theoretical link between the costs of capital and corporate disclosure and to ultimately examine the methodology and reliability of respective empirical studies on the topic. Against this backdrop, the author will cover the following academic objectives:

1. Understanding the rational and components of a firm’s cost of capital.
2. Exploring the distinct types and impacts of corporate disclosure.
3. Clarifying the causal link between the cost of capital and corporate disclosure.
4. Revealing the complexity of a holistic and reliable empirical analysis on the potential relationship.
5. Investigating existing empirical studies and future research suggestions on the topic.

It is, after all, not the objective of this thesis to discuss any of the studies’ results or calculation approaches in perfect mathematical detail. Where applicable, the author refers to published papers that provide a sophisticated examination on the topic.

1.3 Setting the Scene

The vast amount of literature on the link between disclosure and cost of capital can be attributed to the fact that neither of the two components can be observed and directly quantified in the marketplace.⁴ This consequently implies that measuring approaches for the level of disclosure and the cost of capital are affected and partly disturbed by other effects.

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Fig. 1 Extract of Potential Influences on the Research Field⁵

While it is not claimed that Fig. 1 is an exhaustive presentation of all other influences, it should give the reader an idea of the closely linked and mutually dependent nature of the overall topic. Independent fields of research have, in fact, emerged in all of the different streams shown in Fig. 1.

In order to reduce this thesis to a reasonable scope, it will predominantly focus on the direct link between disclosure and the cost of capital in the following. Where applicable, findings of related research fields, in particular the influence of the legal systems, will be used to support or question respective arguments.

1.4 Outline and Structure

The present thesis consists of the following six sections and follows, in essence, Machi and McEvoy’s proposed approach to a comprehensive literature review.⁶

Section 1, Introduction: The general issue and its relevance in regards to the topic are introduced as well as the author’s intention to conduct this thesis.

Section 2, Cost of Capital: This section will introduce the basic concept of capital costs and thereby specify the context of this thesis.

Section 3, Causal Link: The concept of disclosure and its theoretical impact on capital costs, in particular the costs of equity, will be discussed.

Section 4, Measuring Methods: The complexity to empirically prove the potential relationship will be revealed, followed by a discussion of dominant measuring approaches.

Section 5: Empirical Evidence: Existing studies, that both support and question the relationship of disclosure and capital costs will be introduced, discussed and categorised accordingly.

Section 6: Conclusion: An overall assessment of the topic, including the most recent findings, as well as the need for further research will conclude this thesis.

The author, hereby, followed a deductive structure, meaning that the present thesis commences with a general overview of the broad concept of capital costs and continuously divides into the rather sophisticated and focused impact of disclosure on the capital costs.

2 Relevance and Components of the Costs of Capital

The Dictionary of Accounting and Finance defines the cost of capital as the “interest paid on the capital used in operating a business”⁷, which, in essence, describes the “blend of the costs of the different sources of capital”⁸ for any given firm.

Ibbotson and Sinquefield further argue that the cost of capital can be viewed from three different perspectives.⁹ From an investor’s point of view, the cost of capital reflects the respective opportunity costs that are implied by foregoing the returns of an alternative investment with the same level of risk.¹⁰ Therefore, in broader terms, the costs of capital equal the price investors are demanding for the risk they take with their investment.¹¹

From a firm’s perspective, this, in turn, infers that any business seeks to offer an expected return equal or above opportune investments for investors.¹² Scholars, in fact, often refer to the term hurdle rate or required rate of return in the context of a firm’s cost of capital.¹³

Since businesses are generally unwilling to invest in projects that realise returns below this required rate, the cost of capital is, from an internal perspective, employed as the discount rate to assess the expected economic income of potential investments.¹⁴ By decreasing the capital costs, scholars, such as Rappaport, claim that businesses will create value, in terms of shareholder value added or economic profit.¹⁵

Taking a contrasting line, Cheynel argues that capital costs are merely a variable for a price of capital and therefore only relevant for policy makers in assuming market effects, such as the final consumption of investors, following business activities.¹⁶

Pratt and Grabowski and Duff & Phelps LLC further summarised the basic concept of the cost of capital as follows:¹⁷

- Cost of Capital is a consensus assessment of the market and therefore not a function of the investor.
- Cost of Capital is an expected or forward-looking valuation, stated in nominal terms.
- Cost of Capital is based on market values and not on book values.
- Cost of Capital is expressed in percentage terms.

Given the fact that the majority of firms are partly financed by equity and debt, the concept of the weighted average costs of capital (WACC) emerged as the dominant approach for calculating a firm’s overall capital costs.¹⁸ However, there is an ongoing and controversial debate about the composition of an optimal capital structure, following Modigliani and Miller’s irrelevance theorem in the 1950s.¹⁹

(1) Weighted Average Cost of Capital (WACC)

= Fraction of Firm Value financed by Equity × Cost of Equity Capital

+ Fraction of Firm Value financed by Debt × Cost of Debt Capital

With regards to the equation above ^[20] and Koller, Goedhart and Wessels‘ claim that a comprehensive view on the cost of capital includes the required return for each type of investor,²¹ the following sections are set out to discuss the basic concepts of costs of equity and debt respectively.

2.1 Costs of Equity Capital

The ability of enterprises to raise equity capital is, in a sense, the process of receiving cash from public investors without immediate contractual obligations.²² Consequently, contrasting valuation approaches among firms’ executives and public investors arose and mainly stem from the two fundamental problems of agency costs and information asymmetries.²³ On the one hand, differing quality and quantity of firm-specific information have long been recognised as a key issue between the management and shareholders.²⁴ On the other hand, the conflict of interest regarding the effective use of the capital employed, known as the principal-agent problem, has arguably a significant impact on the assessment process of a firm’s present and future value.²⁵

In fact, this gap between investors and executives describes the concept of the cost of equity capital, which Botosan defines as “the minimum rate of return equity investors require for providing capital to the firm”.²⁶ However, since the cost of equity is not directly observable, Botosan, Pratt and Grabowski argue that one has to price the investors’ respective risks in order to estimate the price they are willing to pay for a particular share in an entity.²⁷

Tab. 1 Types of Risk for Equity Holders²⁸

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In summary, a firm only remunerates their shareholders for the market risk, which they are unable to eliminate, compared to the unique risk, which can be mitigated, using a diversified portfolio.²⁹ After all, the importance of risk for shareholders has eventually translated into the two accepted components of the costs of equity shown in equation two ^[30] :

(2) Cost of Equity = Risk Free Rate of Interest + Risk Premium for Market Risk

The generally accepted and widespread Capital Asset Pricing Model (CAPM), as a calculation approach of a firm’s cost of equity capital, also emerged from equation two.³¹ However, the uncertainty of investors about an entity’s payoff distribution plays a both important and contentious role in the context of the present thesis.³² The question as to whether this so-called estimation or information risk can be considered diversifiable or company-specific has fuelled a controversial debate throughout the literature and the reliability of the CAPM.³³ Both issues will be adequately addressed in the following course of this thesis.

Moreover, later parts of this paper will discuss the impact of disclosure in this context in more detail. It is, however, essential to understand at this stage that greater disclosure has the potential to impact shareholders’ value as it causes investors to increase their estimates of expected current or future cash flows.³⁴

2.2 Costs of Debt Capital

The literature, in general, detected two plausible reasons for firms to borrow money from outside debtors. First and foremost, borrowing presents an opportunity for executives to exploit profitable investments, if internal sources of financing are not sufficient.³⁵ Cheaper external financing, partly related to the tax-deductibility of interest rates, have been named a second key advantage of debt compared to equity financing.³⁶

Following Modigliani and Miller’s irrelevance proposition of capital composition³⁷, scholars have started to remodel the traditional view on costs of debt, since information asymmetry and agency costs, again, led to imperfect market conditions.³⁸ In this context, particularly the downsides of potential bankruptcy and reorganisation costs have resulted in a considerable amount of theoretical work on a trade-off between equity and debt.³⁹

Tab. 2 Benefits of Corporate Borrowing⁴⁰

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After all, it can be concluded that companies should be anything but indifferent about their capital structure and rather strive for an optimal debt ratio, in which the estimations of costs of debt play a crucial role.⁴¹

As agreed upon by most scholars, the costs for raising the respective debt funds depend on a risk-free interest rate and the associated default risk.⁴² In this context, Berk et al. add that the current rate of interests differs from the original coupon rate, since existing debt is constantly traded in the marketplace.⁴³

This, in turn, led to the rise of numerous empirical studies that were set out to assess the influence of different aspects, such as board effectiveness, competition and corporate reputation or auditors’ fees, on the cost of debt.⁴⁴

One of these streams, mostly coined by Sengupta, estimates the impact of corporate disclosure on the cost of debt and will be discussed in more detail in the further course of this thesis.⁴⁵

3 Causal Link between Disclosure and Costs of Capital

After understanding the relevance and composition of the costs of capital and in particular the respective risks involved for investors, the following chapter will shed light on the theoretical impact of enhanced levels of disclosure on the capital costs.

The relationship between corporate disclosure and a firm’s cost of capital is expected to be of significant importance for managers and investors respectively. The US Financial Accounting Standards Board presents the fundamental link as follows:

“More information always equates to less uncertainty, and it is clear that people pay more for certainty. Less uncertainty results in less risk and a consequent lower premium being demanded. In the context of financial information, the end result is that better disclosure results in a lower cost of capital.”⁴⁶

The reduction of information asymmetry is, in fact, the key driver behind the impact of disclosure on the cost of capital,⁴⁷ since disclosure generally turns private information into public information.⁴⁸

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Fig. 2 Causal Link between Disclosure and Costs of Capital⁴⁹

It was one of the key objectives of this thesis to clarify, and thereby simplify, the theoretical link of disclosure and costs of capital. Fig. 2 will therefore serve as an orientation guide for the remainder of this work and can be considered as a contribution by the author to organise the escalating literature in this field of study. The theoretical framework, in terms of disclosure in general and its theoretical importance in reducing costs of equity and debt respectively, will be discussed hereafter.

3.1 Disclosure in General

Scholars across all fields propose intensive monitoring of management to address and eventually overcome the information gap between executives and investors. Stulz, in this context, detected six distinct categories of monitoring, including the public disclosure of information.⁵⁰ The availability of firm and market-specific information is, in fact, the key underlying concept of Fama’s generally accepted efficient market hypothesis.⁵¹ Fig. 3 presents the closely related flows of capital and information in such markets.

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Fig. 3 Capital and Information Flows in the Market⁵²

Disclosure, or “the provision of information of all types by a company”⁵³, can be broadly divided into mandatory disclosure, found in annual reports or financial statements, and voluntary disclosure, which covers information that is not explicitly required by accounting or stock market authorities.⁵⁴ Mandatory disclosure essentially aims to force enterprises to achieve a particular quality of earnings;⁵⁵ however, this should rather be considered a minimum benchmark of the information that is required by the market participants.⁵⁶

In fact, today’s fast-moving and dynamic financial world calls for enhanced levels of timely and relevant voluntary disclosure through a variety of information channels.⁵⁷ Moreover, stock-market crashes, as seen in the most recent financial crisis, generally reinforce the distrust of corporate managements and fuel debate about the sufficiency of global disclosure regulations at large.⁵⁸

Despite these externally-determined motives, Watson, Shrives and Marston detected three internal incentives for additional voluntary disclosure. Firstly, the previously stated principal-agent problem may be diminished through increased transparency, since it is a vehicle for managers to convince shareholders that they are acting in an appropriate way. Secondly, economic signalling theory, as an instrument to overcome information asymmetry, may shift executives towards enhanced disclosure policies, given that such moves are expected to signal higher quality and reliability to the markets. Thirdly, voluntary disclosure, especially of non-financial results, is a way for enterprises to signal their legitimacy to certain stakeholder groups, such as environmentalists or governments, which, in turn, increases their confidence in the firm.⁵⁹

Notwithstanding these underlying motives, authors across the field argue that full voluntary disclosure rarely occurs in the actual business environment, which may be due to the fact that the costs of transparency partly offset the respective benefits (Tab. 3).⁶⁰

Tab. 3 Costs and Benefits of Voluntary Disclosure⁶¹

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Following this controversial nature of corporate transparency, scholars have detected a wide range of variables that have proven to affect the level of voluntary disclosure, such as a firm’s profitability, gearing, liquidity, efficiency, size or industry.⁶² From an empirical perspective, however, quantifying the quality and quantity of information remains a major challenge for academics.⁶³ After all, the subsequent chapter four is set out to address this issue in sufficient detail.

3.2 Disclosure to Reduce Costs of Equity

After understanding the costs and benefits of corporate disclosure and its influence on market participants in terms of reducing information asymmetry, the following section is set out to discuss the expected impact for shareholders and the potential changes in their required rates of return.

From an investor’s perspective, the theoretical link between disclosure and cost of equity is captured within two dominant streams of literature (Fig. 4). Firstly, authors, such as Barry and Brown or Coles and Loewenstein, argue that increased levels of disclosure diminish investors’ estimation risk about the firm and thereby lower their overall expected rate of return.⁶⁴

Secondly, Demsetz or Amihud and Mendelson, for instance, suggest that more company-specific information merely reduces investor’s transaction costs and thereby increases the firm’s overall liquidity.⁶⁵

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Fig. 4 Disclosure to Reduce Costs of Equity⁶⁶

After all, both effects are expected to reduce the overall costs of equity capital and will be discussed in more detail hereafter.

However, in the following it will be argued that neither of the two effects is directly assessable in the marketplace and is, in fact, strongly influenced by the measuring technique. The subsequent chapter four will present various approaches that have been utilised to quantify each of the respective components.

3.2.1 Disclosure to Reduce Estimation Risk

The first stream of literature regarding the reduction of costs of equity through enhanced disclosure is essentially coined by Barry and Brown, Handa and Linn and Coles, Loewenstein and Suay.⁶⁷ This early linking evolved from the agency theory and is fundamentally based on the claim that more transparency directly improves manager’s decision making.⁶⁸

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Fig. 5 Disclosure to Reduce Estimation Risk⁶⁹

From an investor’s perspective, estimating firms’ future returns, cash flows or payoff distributions proves to be rather difficult and highly dependent on the information that is provided by executives.⁷⁰ The risk involved in this conflict is called estimation or information risk and describes the fact that

“securities for which there is relatively less information are perceived as relatively more risky because of the greater uncertainty surrounding the exact parameters of their return distribution.”⁷¹

Thus, the assumption is that estimation uncertainty adds another element of risk to the prospects of holding shares in an enterprise.⁷² An extensive and rather controversial discussion has emerged in the literature as to whether or not this risk is diversifiable for investors.⁷³ In fact, it seems inevitable to clarify this issue, since diversifiable or unique risk is not priced in the costs of equity and, in turn, a potential link between disclosure and capital costs would be highly doubtful.⁷⁴

On the one hand, authors in support of the non-diversifiable view argue that investors attribute more systematic risk to an asset with low information than to an asset with high information.⁷⁵ Moreover, as argued by Botosan and Plumlee, estimation risk seems to be not reflected in the market beta as part of the traditional CAPM formula.⁷⁶

On the other hand, however, proponents of the contrasting view that estimation risk is rather firm-specific, base their claim on Reinganum and Smith’s findings that “diversification can be achieved simply by holding [low information and] small firms within a large portfolio”.⁷⁷

After all, Clarkson, Guedes and Thompson conclude this discussion by stating that “the extent of the impact of estimation risk remains, fundamentally, an empirical question”⁷⁸. This implies that the respective measuring approach has a significant influence when assessing the impact of disclosure on the estimation risk, and therefore, eventually, on the costs of equity. Different approaches to quantify investors’ estimation risks will be discussed in section four of this thesis.

3.2.2 Disclosure to Reduce Transaction Costs

In addition to the estimation risk, a second stream of literature detects another disclosure-related cost linked to the information asymmetry issue. In the words of Artiach and Clarkson “investors pay less for stocks with higher transaction costs, thereby leading to higher cost of equity capital”.⁷⁹ Transaction costs, in this context, have been originally defined as “the cost of exchanging ownership titles”⁸⁰, including, but not limited to, “commissions, fees, and direct taxes”.⁸¹

Glosten and Harris, however, question the significance of transaction costs in the economic modelling of asset prices,⁸² with Botosan countering that, in particular, “uninformed investors … require compensation for expected losses from transacting with informed investors”⁸³. The immediate effects of transaction costs are twofold. On the one hand, investors attempt to reduce their information asymmetry component by introducing adverse selection into their evaluation,⁸⁴ which ultimately lowers the liquidity in the market for any given security.⁸⁵ On the other hand, higher transaction costs are expected to widen the so-called bid-ask spread⁸⁶ to the disadvantage of investors.⁸⁷ From a firm’s perspective, shareholders have to be compensated in equilibrium for both illiquidity and unfavourable bid-ask spreads in terms of higher expected returns, meaning higher costs of equity capital.⁸⁸

Consequently, it should be of every firm’s interest to lower the information asymmetry or transaction cost component of the cost of capital in order to reduce their overall hurdle rate.⁸⁹ Enhancing the quality and quantity of disclosure, as argued by Petrova et al., is expected to bring twofold benefits, which are, in fact, congruent with the overall benefits of voluntary disclosure, discussed in the preceding section.⁹⁰

Firstly, more publicly available information, in turn, implies that less private information exists for influential large-scale investors, which levels the playing field in the market and enhances the overall confidence of the investor base.⁹¹ According to Armitage and Marston, this confidence of individual shareholders eventually translates into higher volumes of trading and reduced bid-ask spreads (Fig. 6).⁹²

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Fig. 6 Disclosure to Increased Market Liquidity⁹³

Secondly, the simplified assumption is that, “investors demand more of securities about which they are informed”.⁹⁴ All other things equal, this change in demand increases the liquidity and prices for stocks and eventually increases the firm’s value (Fig. 7).⁹⁵

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Fig. 7 Disclosure to Increased Demand in Stocks⁹⁶

After all, both effects are expected to increase confidence among investors, which not only leads to higher demand and liquidity in the firm’s stocks, but also lowers transaction costs of trading, which, in the end, implies lower rates of expected return and therefore lower costs of equity capital.⁹⁷

3.3 Disclosure to Reduce Costs of Debt

Whilst the theoretical evidence for a link between disclosure and the cost of equity capital has been well documented, literature on the influence on the cost of debt capital is still scarce and essentially limited to a work published by Sengupta in 1998.⁹⁸ However, borrowing is still the dominant form of external financing for publicly traded enterprises and even US rating agency Standard & Poor’s admits that the level of disclosure is one of the essential parts in establishing the rating for an industrial bond.⁹⁹ The lack of empirical studies on the relation between enhanced levels of disclosure and the ultimate cost of debt capital should, after all, be alarming and encourage further research.

Economists and scholars have correspondingly agreed that a firm’s cost of debt capital depends on the risk that incurs to the creditor, with Fisher further arguing that the exact assessment of this risk premium is left largely to speculation.¹⁰⁰ Sengupta, Nikolaev and Van Lent describe this risk as default risk¹⁰¹, or “the possibility that the issuer of a bond will be unable to make payments of principal and interest when they are due”.¹⁰²

In this context, enhanced corporate disclosure is expected to lower the probability that executives withhold adverse or unfavourable information. This, in turn, leads to increased confidence of lenders regarding the default risk of their debtor, which eventually decreases the risk premium they attach to the respective bonds.¹⁰³

However, Armitage and Marston, who took a more praxis-oriented perspective, question this rather unproven claim and argue that costs of debt may hardly be influenced by increased levels of disclosure. They base this assumption on the fact that firms already disclose additional information to their lenders and further increasing this level would barely impact their confidence in the business.¹⁰⁴

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Fig. 8 Disclosure to Reduce Default Risk¹⁰⁵

After all and despite a lack of theoretical and empirical studies on the link between transparency and borrowing costs, one can, however, assume with some certainty that a negative relation exists.¹⁰⁶

[...]

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¹ Verrecchia 1999, p. 272.

² See Hail 2002, p. 742.

³ See Botosan 2006 for the respective paper.

⁴ See Espinosa/Trombetta 2007, p. 1371.

⁵ Figure created by the author, inspired by Cao et al. 2015, p. 42; Cheng/Collins/Huang 2006, p. 176; Stulz 1999, p. 14; Watson/Shrives/Marston 2002, p. 293.

⁶ See Machi/McEvoy 2012 for a comprehensive work on how to conduct a comprehensive literature review.

⁷ Bloomsbury Information Ltd. 2010, p. 88.

⁸ Berk et al. 2013, p. 402.

⁹ See Ibbotson/Sinquefield 2007, p. 21.

¹⁰ See Pratt/Grabowski 2008, p. 3.

¹¹ See Pratt/Grabowski 2008, p. 4.

¹² See Berk et al. 2013, p. 403.

¹³ See Duff & Phelps LLC 2014, p. 11.

¹⁴ See Pratt/Grabowski 2008, p. 4.

¹⁵ See Rappaport 2006, p. 3.

¹⁶ See Cheynel 2013, p. 989.

¹⁷ See Duff & Phelps LLC 2014, pp. 15 - 17; Pratt/Grabowski 2008, pp. 4 - 7.

¹⁸ See McLaney et al. 2004, p. 124.

¹⁹ See Modigliani/Miller 1958 and Modigliani/Miller 1963 for the original papers.

²⁰ See equation, as shown in Berk et al. 2013, p. 404.

²¹ See Koller/Goedhart/Wessels 2010, p. 291.

²² See Stulz 1999, p. 13.

²³ See Stulz 1999, p. 9.

²⁴ See Akerlof 1970; Stiglitz/Weiss 1981 for the original papers on information asymmetry.

²⁵ See Stulz 1999, p. 9 or Jensen 1986; Jensen/Meckling 1976 for the original discussion on the principal-agent problem.

²⁶ Botosan 2006, p. 31.

²⁷ See Botosan 2006, p. 32; Pratt/Grabowski 2008, p. 46.

²⁸ Table created by the author, referring to risks as identified by Brealey/Myers/Allen 2008, p. 188; Pratt/Grabowski 2008, p. 55 for maturity risk; Berk et al. 2013, p. 353; Pratt/Grabowski 2008, p. 56 for market risk; Berk et al. 2013, p. 355; Pratt/Grabowski 2008, p. 56 for unique risk and Pratt/Grabowski 2008, p. 57 for liquidity risk.

²⁹ See Vernimmen et al. 2014, p. 422.

³⁰ See equation, as shown in Botosan 2006, p. 31.

³¹ See Botosan 2006, p. 31.

³² See Botosan 2006, p. 34.

³³ See the original papers of Barry/Brown 1985; Coles/Loewenstein 1988; Coles/Loewenstein/Suay 1995; Handa/Linn 1993; Klein/Bawa 1976 for a sophisticated debate about the diversification of estimation risk.

³⁴ See Cooper 2006, p. 42.

³⁵ See Jensen/Meckling 1976, p. 342.

³⁶ See Kraus/Litzenberger 1973, p. 911.

³⁷ See Modigliani/Miller 1958 and Modigliani/Miller 1963 for the original papers.

³⁸ See Francis/Khurana/Pereira 2005, p. 1172.

³⁹ See Binsbergen et al. 2010, p. 2089.

⁴⁰ Table created by the author, referring to Bradley/Jarrell/Kim 1984; Scott 1976 for the Static Trade-Off Theory; Myers 1984; Myers/Majluf 1984 for the Pecking Order Theory and Jensen 1986 for the Cash Flow Theory.

⁴¹ See Bradley/Jarrell/Kim 1984, p. 857; DeAngelo/Masulis 1980, p. 4.

⁴² See, for instance, Beltrame/Cappelletto/Toniolo 2014, p. 405; Merton 1974, p. 449. Default risk may be defined as the possibility that the issuer of a bond will be unable to make payments of principal and interest when they are due, as defined by Bloomsbury Information Ltd. 2010, p. 103.

⁴³ See Berk et al. 2013, p. 405.

⁴⁴ See Lorca/Sánchez-Ballesta/García-Meca 2011 for the influence of board effectiveness; Valta 2012 for the influence of competition; Anginer et al. 2011 for the influence of corporate reputation and Dhaliwal et al. 2008 for the influence of auditor fees.

⁴⁵ See Sengupta 1998 for the respective paper.

⁴⁶ Foster 2003, p. 1.

⁴⁷ See Easley/O'Hara 2004, p. 1554; Lambert/Leuz/Verrecchia 2007, p. 386.; Petrova et al. 2012, p. 83.

⁴⁸ To understand the concept of private or “insider” knowledge and publicly available information, consider an uninformed investor, faced with a choice between two assets, which are identical except that one asset has less public information and more private information. The uninformed investor loses to the informed investors who know the private information, and so requires a greater expected return to hold the asset with more information risk. As explained by Aslan et al. 2006, p. 5.

⁴⁹ Figure created by the author.

⁵⁰ See Stulz 1999, p. 14 f.

⁵¹ See Barker 1998, p. 3 or Fama 1970 for the original paper on the efficient market hypothesis.

⁵² Figure created by the author, adapting the model in Healy/Palepu 2001, p. 408.

⁵³ Armitage/Marston 2008, p. 315.

⁵⁴ See Financial Accounting Standards Board 2001, p. 5; Lang/Lundholm 1996, p. 468.

⁵⁵ See Verrecchia 1999, p. 272.

⁵⁶ See Holland 1998, p. 256.

⁵⁷ See Gietzmann/Trombetta 2003, p. 187.

⁵⁸ See Eccles/Mavrinac 1995, p. 11; Patel/Dallas 2002, p. 3; Welker 1995, p. 802.

⁵⁹ See Watson/Shrives/Marston 2002, pp. 290 - 293.

⁶⁰ See Admati/Pfleiderer 2000, p. 480; Skinner 1994, p. 39.

⁶¹ Table created by the author, referring to Healy/Hutton/Palepu 1999, p. 488; Holland 1998, p. 259 for enhanced confidence; Leuz/Wysocki 2006, p. 193 for increased liquidity; Vishwanath/Kaufmann 2001, p. 45 for direct costs; Admati/Pfleiderer 2000, p. 480; Leuz/Wysocki 2006, p. 196 for indirect costs.

⁶² See Watson/Shrives/Marston 2002, p. 293 f.

⁶³ See Leuz/Verrecchia 2000, p. 99.

⁶⁴ See Barry/Brown 1985; Coles/Loewenstein 1988 for the original papers.

⁶⁵ See Amihud/Mendelson 1986; Demsetz 1968 for the original papers.

⁶⁶ Figure created by the author using the framework of Vernimmen et al. 2014, p. 269.

⁶⁷ See Barry/Brown 1985; Coles/Loewenstein/Suay 1995; Handa/Linn 1993 for the respective papers.

⁶⁸ See Lambert 2001, p. 4; Shevlin 2013, p. 22.

⁶⁹ Figure created by the author referring to Poshakwale/Courtis 2005, p. 431.

⁷⁰ See Espinosa/Trombetta 2007, p. 1374; Petrova et al. 2012, p. 84; Poshakwale/Courtis 2005, p. 432.

⁷¹ Artiach/Clarkson 2011, p. 7.

⁷² See Botosan 2006, p. 33; Handa/Linn 1993, p. 81.

⁷³ See Armitage/Marston 2008, p. 316; Shevlin 2013, p. 23.

⁷⁴ See Armitage/Marston 2008, p. 317.

⁷⁵ See Espinosa/Trombetta 2007, p. 1374 or Handa/Linn 1993, p. 81 for a more general discussion.

⁷⁶ See Botosan/Plumlee 2002, p. 23.

⁷⁷ Reinganum/Smith 1983, p. 223.

⁷⁸ Clarkson/Guedes/Thompson 1996, p. 79.

⁷⁹ Artiach/Clarkson 2011, p. 11.

⁸⁰ Demsetz 1968, p. 35.

⁸¹ Bloomsbury Information Ltd. 2010, p. 321.

⁸² See Glosten/Harris 1988, p. 123.

⁸³ Botosan 2006, p. 34.

⁸⁴ Adverse selection refers to a situation where sellers have more information than buyers. Buyers usually translate this uncertainty into the prices they are willing to pay; as defined by Bloomsbury Information Ltd. 2010, p. 9.

⁸⁵ See Joos 2000, p. 125.

⁸⁶ Bid-ask spreads may be defined as the differential between the highest price a prospective buyer is prepared to pay (bid) and the lowest price a seller is willing to accept (ask). Market makers in a particular security make their money off of this spread. As defined by Ibbotson/Sinquefield 2007, p. 156.

⁸⁷ See Amihud/Mendelson 1986, p. 223.

⁸⁸ See Leuz/Wysocki 2006, p. 193.

⁸⁹ See Verrecchia 2001, p. 165.

⁹⁰ See Petrova et al. 2012, p. 84.

⁹¹ See Clement/Frankel/Miller 2000, p. 10; Leuz/Wysocki 2006, p. 193.

⁹² See Armitage/Marston 2008, p. 316.

⁹³ Figure created by the author, referring to Leuz/Wysocki 2006, p. 193; Petrova et al. 2012, p. 84.

⁹⁴ Botosan 2006, p. 34.

⁹⁵ See Armitage/Marston 2007, p. 5.

⁹⁶ Figure created by the author referring to Botosan 2006, p. 34 and more generally to Diamond/Verrecchia 1991.

⁹⁷ See Armitage/Marston 2008, p. 316.

⁹⁸ See Botosan 2006, p. 39; Wang/Sewon/Claiborne 2008, p. 16.

⁹⁹ See Standard & Poor's 1983, as cited in Sengupta 1998, p. 459.

¹⁰⁰ See Fisher 1959, p. 217.

¹⁰¹ See Nikolaev/Van Lent 2005, p. 678.; Sengupta 1998, p. 459.

¹⁰² Bloomsbury Information Ltd. 2010, p. 103.

¹⁰³ See Sengupta 1998, p. 461.

¹⁰⁴ See Armitage/Marston 2008, p. 327.

¹⁰⁵ Figure created by the author, referring to Sengupta 1998, p. 461.

¹⁰⁶ See Raffournier 1995, p. 264.