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Journal of Accounting Research

Vol. 40 No. 1 March 2002


Printed in U.S.A.

A Re-examination of Disclosure
Level and the Expected Cost
of Equity Capital
C H R I S T I N E A . B O T O S A N∗ A N D M A R L E N E A . P L U M L E E∗

Received 10 January 2000; accepted 8 October 2001

ABSTRACT

This paper examines the association between the cost of equity capital and
levels of annual report and timely disclosure, and investor relations activities.
We estimate the cost of equity capital using the classic dividend discount model.
We find that the cost of equity capital decreases in the annual report disclosure
level but increases in the level of timely disclosures. The latter result is contrary
to theory but is consistent with managers’ claims that greater timely disclosures
may increase the cost of equity capital, possibly through increased stock price
volatility. We find no association between the cost of equity capital and the level
of investor relations activities. We conclude that aggregating across different
disclosure types results in a loss of information. Failing to include all disclosure
types in regression analyses may lead to a correlated omitted variable bias and
erroneous conclusions.

I. Introduction
This paper explores the association between the expected cost of equity
capital and three types of disclosure (annual report, quarterly and other

∗ University of Utah. The authors would like to thank Professor Shelley Rhoades for her

assistance in using Mathematica and Professor Nicolas Bollen for his assistance with the numer-
ical approximation program. We would also like to thank our anonymous reviewer, Andrew
Christie, Myron Gordon, Neil Bhattacharya, Uri Loewenstein, Jim Ohlson, Taylor Randall and
the workshop participants at the 2000 American Accounting Association Annual Meeting,
Louisiana State University, The Eleventh Annual Conference of Financial Economics and Ac-
counting at the University of Michigan, New York University, University of Notre Dame, and
the University of Utah for their helpful comments and suggestions.

21
Copyright 
C , University of Chicago on behalf of the Institute of Professional Accounting, 2002
22 C . A . BOTOSAN AND M. A . PLUMLEE

published reports, and investor relations) examined by the Association


for Investment Management and Research in their Corporate Information
Committee’s Annual Reviews of Corporate Reporting Practices (AIMR reports).
As expected, we find that the cost of equity capital is decreasing in annual
report disclosure level. The magnitude of the difference in the cost of eq-
uity capital between the firms providing the most annual report disclosure
relative to those providing the least is approximately 0.7 percentage points,
after controlling for market beta and firm size. In contrast to our expec-
tations, however, we find a positive association between the cost of equity
capital and the level of more timely disclosures, such as the quarterly report
to shareholders. We show that the cost of equity capital is approximately
1.3 percentage points higher for firms providing the most quarterly and
other published report disclosure relative to firms providing the least of this
type of disclosure, after controlling for market beta and firm size. This re-
sult, while contrary to that predicted by theory, is consistent with managers’
claims that greater timely disclosure increases the cost of equity capital,
possibly through increased stock price volatility. Finally, we find no associ-
ation between the cost of equity capital and the level of investor relations
activities.
Using annual report disclosures for one industry, within a single year,
Botosan [1997] documents a negative association between the cost of eq-
uity capital and voluntary disclosure level for firms with a low analyst follow-
ing but finds no association between these variables for firms with a high
analyst following. Our results, based on a much larger sample, suggest that
firms with a high analyst following benefit from providing greater annual re-
port disclosure. Moreover, this paper addresses two important questions left
unanswered by Botosan [1997]. Does type of disclosure matter? Our results
suggest that type of disclosure is critical since we document negative, posi-
tive, and no association between disclosure level and the cost of equity cap-
ital depending on disclosure type. Do the results generalize to a sample not
limited to one year [1990] or one industry (machinery)? Our analysis con-
firms and extends the results documented in Botosan [1997] for low analyst
following firms to a sample comprised of large, heavily followed firms rep-
resenting 43 different industries and spanning an eleven-year period from
1986–1996.

II. Hypothesis Development


A number of recent empirical studies suggest a link between the cost of
equity capital and disclosure. For example, Frankel, McNichols, and Wilson
[1995] find that managers of firms that access the capital markets provide
more frequent management earnings forecasts. Welker [1995] documents
a negative association between disclosure levels and relative bid-ask spreads.
As discussed previously, Botosan [1997] documents a negative association
between the cost of equity capital and disclosure level for firms with a low
analyst following. Healy, Hutton, and Palepu [1999] find that firms that
DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 23

increase their disclosure level experience increases in stock performance,


institutional ownership, analyst following, and stock liquidity. Finally, Lang
and Lundholm [2000] conclude that firms that increase their disclosure
level in anticipation of a stock offering experience price increases prior to
the offering.
Each of the studies described in the preceding paragraph relies on two
streams of theoretical research to support the hypothesis that greater dis-
closure is associated with a lower cost of equity capital. The first stream
suggests that greater disclosure enhances stock market liquidity, thereby re-
ducing the cost of equity capital either through reduced transaction costs
or increased demand for a firm’s securities.1 For example, Amihud and
Mendelson [1986] suggest that the cost of equity capital is greater for secu-
rities with wider bid-ask spreads because investors require a higher return to
compensate for added transaction costs. Disclosing information allows firms
to reduce the adverse selection component of the bid-ask spread, thereby
reducing their cost of equity capital. Diamond and Verrecchia [1991] claim
that greater disclosure reduces the amount of information revealed by a
large trade. When the adverse price impact of such a trade is reduced, in-
vestors are willing to take larger positions in a firm’s securities, thereby
increasing the demand for its securities and reducing its cost of equity
capital.
The second stream of research suggests that greater disclosure reduces
the estimation risk associated with investors’ assessments of the parameters
of an asset’s return or payoff distribution.2 These researchers maintain that
investors estimate the parameters of a security’s payoff distribution based
on available information about the firm. Using a Bayesian approach and
realizing that investors form predictive distributions as a function of their
uncertainty about the true parameters, Barry and Brown [1985], Handa
and Linn [1993], and Coles, Loewenstein, and Suay [1995] conclude that
estimation risk (or information risk) is nondiversifiable. They also suggest
that the traditional CAPM formula for market beta does not reflect this
risk, resulting in estimates of market beta that are too low for low infor-
mation securities. To date, there is no consensus in the literature regard-
ing the diversifiability or lack thereof, of estimation risk (Clarkson, et. al
[1996]).
The theoretical and empirical research, discussed above, support the fol-
lowing hypothesis:
Ha : There is a negative association between the cost of equity capital
and disclosure level.

1 See for example, Demsetz [1968], Copeland and Galai [1983], Glosten and Milgrom

[1985], Amihud and Mendelson [1986] and Diamond and Verrecchia [1991].
2 See for example, Klein and Bawa [1976], Barry and Brown [1985], Coles and Loewenstein

[1988], Handa and Linn [1993], Coles, et al. [1995], and Clarkson, et. al. [1996].
24 C . A . BOTOSAN AND M. A . PLUMLEE

III. Sample Selection


Our sample selection begins with the 4,705 firm-year observations in-
cluded in the AIMR Reports dated from 1985/86 through 1995/96.3 We
require Value Line forecasts to calculate our measure of the expected cost
of equity capital, so our sample is limited to firms followed by Value Line.
This reduces our sample by 23% to 3,623 firm-year observations. Even when
Value Line follows a firm, the data necessary to form our cost of equity capital
measure are not always available. Eliminating these observations from the
sample yields a final sample of a maximum of 3,618 firm-year observations.
Table 1 summarizes our sample selection procedures and shows the dis-
tribution of the 3,618 firm-year observations across industries (panel B) and
years (panel C). The number of times a given firm appears in the sample
is provided in panel D. As shown in panel B, the sample is well dispersed
across industries. No one industry contributes greater than 10% of the ob-
servations to the sample except for banking, which accounts for 11.25% of
the total. The sample is fairly evenly distributed across years as well, with
1991 contributing the largest proportion of observations of any single year
(12.05%). Our sample includes 668 individual firms. Of these, 110 firms
(16.47% of the number of firms) appear in our sample in only one year.
However, 72 firms (10.78% of the number of firms) appear in the sample in
all eleven years and contribute 21.89% of the firm-year observations. Since
the same firm can appear multiple times in our data we perform sensitivity
analyses to ensure that our conclusions are not sensitive to the inclusion of
multiple observations per firm.

IV. The Model and Empirical Proxies


THE MODEL
We test our hypothesis by regressing the expected cost of equity capital
(r) on market beta (BETA), the natural log of market value (LMVAL), and
fractional disclosure rank (RDSCR).That is,
r it = γ0 + γ1 BETAit + γ2 LMVALit + γ3 RDSCR it + εit . (1)
Using alternative specifications of regression equation (1), we examine
the impact on the cost of equity capital of cross-sectional variation in total
disclosure level and cross-sectional variation in disclosure level by type of
disclosure. The three types of disclosure we examine are those included in
the AIMR Reports: annual report, other publications, and investor relations.
Consequently, in our empirical analysis we replace RDSCR by RTSCR (the

3 Typically, the AIMR produces scores or ranks for each category of disclosure (annual

and other required reports, quarterly reports and other published information and investor
relations) and a total score or rank for each firm within an industry. In some instances, however,
only total scores or ranks are reported. This reduces our overall sample size when category
scores or ranks are used as independent variables.
DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 25

TABLE 1
Sample Selection Procedures
The table below shows the determination of the sample and the distribution of firm-year
observations by industry membership, year and frequency. Industry names and the allocation
of firm-year observations across industries are taken from the Annual Reviews of Corporate
Reporting Practices prepared by the Corporate Information Committee of the Association for
Investment Management and Research.

Panel A: Sample selection process # %


Total firm-years followed by AIMR 4705 100.0
Total firm-years not followed by Value Line 1082 23.0
Total firm-years with insufficient data 5 0.1
Total firm-year observations 3618 76.9

Observations by industry
Years in
Panel B: Sample breakdown by industry Sample # %
Aerospace 86–91 66 1.82
Airline 86–96 90 2.49
Apparel 86–94 82 2.27
Automotive 96 11 0.30
Banking 86–93 407 11.25
Canadian Banking 94–96 1 0.03
Chemical 87–95 104 2.87
Coal Mining 91–92 6 0.17
Computer and Electrical 89–92 53 1.46
Construction 89–96 52 1.44
Container and Packaging 89–93 42 1.16
Diversified Companies 88–93 49 1.35
Domestic Oil 86–96 98 2.71
Domestic Oil Refining 91–96 24 0.66
Drilling and Oil 86 8 0.22
Electrical Equipment 86–96 100 2.76
Environmental Control 86–96 54 1.49
Financial Services Industries 86–94 98 2.71
Food, Beverage and Tobacco 86–96 209 5.78
Health Care 86–96 180 4.98
Health Care Services 87–88 7 0.19
Independent Oil 88–92 28 0.77
Insurance Sub 86–96 272 7.52
International Oil 86–96 76 2.10
International Pharmaceuticals 92–94 3 0.08
Machinery 86–95 150 4.15
Motor Carrier 86–91 34 0.94
Natural Gas Distributors 86–96 104 2.87
Natural Gas Pipeline 86–95 105 2.90
Nonferrous & Mining 90–92 26 0.72
Oil and Gas Drilling 91–92 44 1.22
Oil Service and Equipment 87–90 14 0.39
Paper and Forest Products 88–96 154 4.26
Precious Metals 91–96 49 1.35
Publishing and Broadcasting 86–96 178 4.92
Railroad 86–96 69 1.91
Retail Trade 86–96 281 7.77
26 C . A . BOTOSAN AND M. A . PLUMLEE

T A B L E 1—Continued
Observations by industry
Years in
Panel B: Sample breakdown by industry Sample # %
Savings Institutions 89–93 19 0.53
Service Oil 86 8 0.22
Software Data 89–93 101 2.79
Specialty Chemicals 86–94 122 3.37
Telecommunications 94 5 0.14
Textiles 86–94 35 0.97
Total firm-year observations 3618 100.00
Observations by year

Panel C: Sample breakdown by year # %


1986 293 8.10
1987 296 8.18
1988 295 8.15
1989 381 10.53
1990 426 11.78
1991 436 12.05
1992 419 11.58
1993 377 10.42
1994 258 7.13
1995 228 6.30
1996 209 5.78
Total firm-year observations 3618 100.00

Firms Observations

Panel D: # of times a given firm appears # % # %


1 110 16.47 110 3.04
2 63 9.43 126 3.48
3 65 9.73 195 5.39
4 69 10.33 276 7.63
5 52 7.78 260 7.18
6 53 7.93 318 8.79
7 42 6.29 294 8.13
8 69 10.33 552 15.26
9 35 5.24 315 8.71
10 38 5.69 380 10.50
11 72 10.78 792 21.89
Total firms and firm-year observations 668 100.00 3618 100.00

fractional rank of the AIMR’s total disclosure score) in one specification


of the model. In the alternative specification RDSCR is replaced by three
disclosure measures: RANLSCR (the fractional rank of the annual report
score), ROPBSCR (the fractional rank of the other publication score), and
RINVSCR (the fractional rank of the investor relations score).4

4 For completeness we also examine three specifications of equation (1) in which RDSCR

is replaced first by RANLSCR, then by ROBPSCR and finally by RINVSCR.


DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 27

The disclosure ranks (RTSCR, RANLSCR, ROPBSCR, and RINVSCR) are


computed based on a within industry/year ranking of the sample data. These
measures are discussed in more detail in the next section of the paper, as is r,
our estimate of the firm’s expected cost of equity capital.
BETA is included in the models to control for systematic risk. We esti-
mate BETA by the market model using a minimum of thirty monthly return
observations over the five-year period ended June 30 of the AIMR Report
publication year with a value-weighted NYSE/AMEX market index return.5
We take data used in the computation of BETA from the 1998 version of the
CRSP tape. Occasionally, sufficient data to compute BETA are not available
on CRSP. In these instances we substitute Value Line’s estimate of market
beta.
LMVAL is included in the analyses because prior research documents a
significant association between market value and both the expected cost of
equity capital and disclosure level. This suggests market value might induce
a correlated omitted variable bias if excluded from the analysis. We use
the natural log of the market value of outstanding common equity as at
December 31 of the year preceding the AIMR Report publication year in our
tests. We obtain market value of common equity from the CRSP tape. In
those instances where market value of common equity is missing on CRSP,
we collect it from the 1998 version of the COMPUSTAT tape.
We limit our control variables to BETA and LMVAL. In comparison,
Gebhardt, Lee, and Swaminathan (GLS) [2001] include eight firm charac-
teristics in their regression of the expected cost of equity capital on various
firm and industry characteristics. While this is appropriate for the research
question addressed in GLS, our purpose, which is ultimately to examine the
association between the expected cost of equity capital and disclosure level,
is clearly different.6
DESCRIPTIVE STATISTICS PERTAINING TO MARKET BETA AND FIRM SIZE
Panel A of table 2 provides descriptive statistics for firm size and market
beta for the sample pooled across years. The data show that the mean (and
median) firm included in the sample is very large. The mean market value
of common equity (MVAL) is $4.97 billion; the median is $1.98 billion.
This is in sharp contrast to the mean and median firm size of the sample
employed in Botosan [1997], $713 million and $209 million, respectively.
Clearly, limiting the analysis to firms included in the AIMR Reports produces

5 AIMR Reports tend to be published in the last quarter of the year. We assume that each

report assesses firms’ disclosure practices during a one-year period ending June 30 of the
publication year. For example, the 1993/94 report was published in November of 1994. We
assume this report evaluates disclosures made by firms during the period July 1, 1993 through
June 30, 1994.
6 The purpose of the GLS study is to describe the cross-sectional relation between expected

cost of equity capital and a survey of firm and industry characteristics found in prior research
to be statistically associated with realized returns. None of the variables examined in GLS is a
measure of disclosure level.
28 C . A . BOTOSAN AND M. A . PLUMLEE

TABLE 2
Descriptive Statistics During the Period 1986–1996 for Both Pooled Sample and Year-by-Year
The table below provides descriptive statistics for the sample pooled across the sample pe-
riod 1986–1996 and on an annual basis. Our data set includes 3,618 total disclosure ranks
but only 3,463 total disclosure scores since only rank data are provided for some industries.
The number of observations with category disclosure scores is less than 3,463 because some
industry subcommittees do not breakdown the total disclosure score by disclosure category.
The number of disclosure scores for the investor relation category slightly exceeds the num-
ber of disclosure scores for the annual report and other publications categories because the
Oil Service and Drilling Industry Subcommittee did not disclose annual report and other
publication scores in 1987. MVAL is the market value of common equity on December 31st
of the year prior to the publication year of the A IMR Report. BETA is estimated via the mar-
ket model using a minimum of 30 monthly returns over the 60 months prior to June of the
publication year of the A IMR Report. We estimate the market model with a value weighted
NYSE/AMEX market index return. DANLSCR (DOPBSCR, DINVSCR, DTSCR) is the indus-
try/year mean-differenced annual report (other publications, investor relation, total) score.
The mean-differenced disclosure scores are computed by subtracting the industry/year av-
erage score for a given disclosure category from the firm’s score. We convert this into a
percentage figure by dividing the difference by the proportion of total points allocated to the
given category and multiplying the result by one hundred. The resulting figure is the number
of percentage points by which a given firm’s score deviates from the industry mean score for
a given year. rDIV is the estimated cost of equity capital derived from the dividend discount
formula.
Panel A: Pooled sample
Variable MVAL BETA DANLSCR DOPBSCR DINVSCR DTSCR rDIV
n 3618 3618 2419 2419 2433 3463 3618
Mean 4967.7 1.106 0.000 0.000 0.000 0.000 0.165
Percentiles:
1% 83.2 0.237 −23.706 −30.227 −35.686 −30.126 0.024
25% 795.5 0.888 −5.127 −6.480 −6.833 −5.448 0.120
50% 1976.0 1.101 0.464 0.833 1.418 1.039 0.156
75% 4747.4 1.314 5.520 7.333 8.565 6.364 0.202
99% 54484.0 2.131 19.950 23.793 24.882 20.365 0.393
Std. Dev. 9690.2 0.373 8.723 11.306 12.670 9.947 0.073
Panel B: Year-by-year results
Year MVAL BETA DANLSCR DOPBSCR DINVSCR DTSCR rDIV
1986 2667.4 1.068 0 0 0 0 0.144
1168.9 1.061 1.132 0.902 1.619 0.983 0.141
293 293 190 190 190 285 293
1987 3069.2 1.087 0 0 0 0 0.128
1449.4 1.086 0.185 1.667 1.685 1.078 0.129
296 296 199 199 214 296 296
1988 3286.6 1.088 0 0 0 0 0.190
1695.4 1.059 −0.029 0.833 1.288 0.217 0.188
295 295 213 213 213 295 295
1989 3296.8 1.120 0 0 0 0 0.160
1514.6 1.118 0.476 1.235 1.360 1.200 0.154
381 381 252 252 251 365 381
1990 4267.1 1.122 0 0 0 0 0.220
1947.4 1.107 0.569 1.065 1.005 0.850 0.208
426 426 298 298 298 405 426
DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 29
T A B L E 2—Continued
Panel B: Year-by-year results
Year MVAL BETA DANLSCR DOPBSCR DINVSCR DTSCR rDIV
1991 4037.4 1.149 0 0 0 0 0.176
1571.0 1.136 0.204 0.236 0 0.841 0.164
436 436 263 263 263 393 436
1992 5465.1 1.124 0 0 0 0 0.176
2052.2 1.128 0.387 0 1.998 1.229 0.166
419 419 256 256 256 373 419
1993 5993.7 1.169 0 0 0 0 0.148
2758.3 1.192 0.759 0.938 2.187 1.385 0.145
377 377 245 245 245 356 377
1994 7254.6 1.089 0 0 0 0 0.162
3215.9 1.098 0.143 0.781 1.849 0.828 0.160
258 258 193 193 193 258 258
1995 8048.2 1.038 0 0 0 0 0.134
3341.9 1.059 0.464 1.782 2.106 1.172 0.132
228 228 164 164 164 228 228
1996 10637.0 1.004 0 0 0 0 0.127
3879.9 0.945 1.107 0.624 0.826 0.279 0.126
209 209 146 146 146 209 209

a sample of larger firms that tend to be more heavily followed by financial


analysts.7
Panel B provides similar information to panel A but on a year-by-year
basis. The average (median) sample firm’s market value of common eq-
uity was $2.67 ($1.17) billion in 1986. By 1996 this had grown to $10.64
($3.88) billion. Mean year-by-year BETA’s are comparable to their corre-
sponding medians. Mean BETA increases virtually monotonically during
the first eight years of the sample period, peaking in 1993 at 1.169, followed
by a monotonic decline to 1.004 during the last three years of the period.
DISCLOSURE DATA
Our disclosure data are drawn from the 1985/86–1995/96 AIMR Reports.
The stated goal of the AIMR Reports is to “improve corporate communica-
tions between the investment community and the management of publicly
owned corporations in the United States and elsewhere” [1995/96 AIMR
Report, p. 1]. Each year the AIMR selects a number of industries for con-
sideration and forms industry subcommittees responsible for assessing the
adequacy of the corporate reporting practices of firms within the industry.
The subcommittees use a checklist drawn from guidelines provided by the
AIMR to evaluate companies within their industries. The guidelines suggest
three categories of disclosure be evaluated: (1) annual published and other

7 Lang and Lundholm [1996] show that the number of analysts following the average AIMR

firm during 1985 through 1989 is 17.6. In contrast, the number of analysts following the average
firm in Botosan’s low analyst following sub-sample is 4.8 analysts.
30 C . A . BOTOSAN AND M. A . PLUMLEE

required information, (2) quarterly and other published information not


required, and (3) other aspects. The suggested weights applied to each
category in arriving at the total score are 40–50%, 30–40%, and 20–30%.
It can be inferred from these suggested weights that the annual report is
viewed as a particularly important document.
“The annual published and other required information” category con-
siders the clarity and completeness of the annual report (including the
financial statements and footnotes) and required published information
such as 10-Ks and 10-Qs. “The quarterly and other published information
not required” category is concerned with the depth, clarity, and timeliness
of the quarterly report to shareholders, proxy statements, annual meet-
ing reports, fact books, press releases, and newsletters. Finally, access to
management through presentations to analysts, company-sponsored field
trips, and interviews is the focus of the “other aspects” category.
While the guidelines provided to the subcommittees are fairly detailed
and extensive, the subcommittees often deviate substantially from them and
develop disclosure indices tailored to the unique characteristics of their
industries. We convert the AIMR disclosure scores to within industry/year
fractional disclosure ranks, defined as the rank of a given firm’s disclosure
score divided by the number of observations having nonmissing values of
the ranking variable. We rank firms in ascending order, such that firms
providing higher levels of disclosure receive higher ranks. As a result, if
greater disclosure results in a lower cost of equity capital, the coefficient on
the disclosure rank will be negative.
DESCRIPTIVE STATISTICS PERTAINING TO THE DISCLOSURE DATA
Table 2 presents descriptive statistics for the disclosure data. Panel A pro-
vides information pertaining to the pooled sample while panel B gives year-
by-year statistics. This table presents industry mean-differenced disclosure
scores as opposed to disclosure ranks because scores provide a better sense
of the cross-sectional distribution of the disclosure measures.8 The industry
mean-differenced disclosure scores presented in this table are computed by
subtracting the industry/year average score for a given disclosure category
from a given firm’s score. We convert this into a percentage figure by divid-
ing the difference by the proportion of total points allocated to the given
category and multiplying the result by one hundred. The resulting figure is
the number of percentage points by which a given firm’s score deviates from
the industry mean score for a given year. The overall and year-by-year aver-
age mean-differenced scores are all zero due to this procedure. However,
the distribution of the three category mean-differenced scores (DANLSCR,

8 There are fewer than 3,618 observations for DTSCR because only rank data are available

in some industries. As a result these observations are not included in the computations based
on scores, however, they are included in subsequent analysis based on ranks. In addition, the
number of observations by disclosure category is always less than the number of observations in
the total disclosure category because some industry subcommittees do not generate category
scores.
DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 31

DOPBSCR and DINVSCR) and the total mean-differenced score (DTSCR)


indicate variation in disclosure levels. For example, at the 75th percentile
the total disclosure score is 6.364 percentage points greater than the indus-
try average for the given year. At the 25th percentile the total disclosure
score is 5.448 points lower than the corresponding industry/year average.
Depending on the disclosure measure, the inter-quartile range is between
11 and 15 percentage points.
THE COST OF EQUITY CAPITAL
We estimate the cost of equity capital (denoted below as rDIV ) for each
firm-year using the short horizon form of the classic dividend discount
model given in equation (2), below.9

4
Pt = (1 + r )−τ E t [dt+τ ] + (1 + r )−4 P4 (2)
τ =1

Where: Pt = price at date t


r = the expected cost of equity capital
E t (o) = the expectations operator
dt = dividends per share for year t

We collect forecasts of dividends for fiscal years t + 1 and t + 2 and the


long-range dividend forecast and maximum and minimum future price esti-
mates from forecasts published by Value Line during the third quarter of the
AIMR Report publication year. Since Value Line does not provide a dividend
forecast for t + 3, we interpolate between the t + 2 and long-range dividend
forecasts to obtain an estimated forecast of dividends for t + 3. We compute
the forecast of price in year T = 4 (P4 ) by taking the mean of the minimum
and maximum long-run price forecasts provided by Value Line.10
We take the current stock price (Pt ) from CRSP on the Value Line publica-
tion date or the closest date thereafter within three days of publication. We
substitute Value Line’s “recent price” for price when price data is not available
on the CRSP tape. In addition, we compare all CRSP price data to Value Line’s
recent price data to identify potential problems arising from stock splits or
stock dividends. If the difference between the CRSP price andValue Line’s
recent price is greater than 15%, we substitute Value Line’s recent price for
the CRSP price.

9 Although Botosan [1997] derives her estimates from the Edwards-Bell-Ohlson (EBO)

valuation model, the estimates produced by these two approaches should be identical barring
any violations of the clean-surplus relation (Lundholm and O’Keefe [2001]). It is not surprising
then that the Spearman rank-order correlation between the estimates is 0.90 (Botosan and
Plumlee [2001]). Since the estimates produced by the dividend discount formula are invariant
to violations of the clean-surplus relation, we employ the estimates produced by this model.
However, all results hold if the cost of equity capital estimates derived from the EBO valuation
model are used instead.
10 Alternatively the price implicit in Value Line’s long-range P/E ratio could be used. As

discussed in Botosan [1997] both approaches yield virtually identical results.


32 C . A . BOTOSAN AND M. A . PLUMLEE

DESCRIPTIVE STATISTICS PERTAINING TO THE COST OF EQUITY


CAPITAL ESTIMATES
Table 2, panel A provides descriptive statistics pertaining to our cost of eq-
uity capital estimates for the pooled sample. The mean (median) expected
cost of equity capital (i.e. rDIV ) is 16.5% (15.6%). The standard deviation of
the estimates is 7.3%, with an interquartile range of 8.2%. Table 2, panel B
gives year-by-year mean and median data for our expected cost of equity
capital estimates. The estimates suggest an upward trend in the mean cost
of equity capital during the latter part of the 1980s (peaking in 1990 at 22%),
followed by a downward trend during the first half of the 1990s.

V. Empirical Results
UNIVARIATE ANALYSIS OF THE ASSOCIATION BETWEEN THE COST
OF EQUITY CAPITAL AND DISCLOSURE LEVEL
Table 3 presents the average of the year-by-year Spearman correlation
coefficients among rDIV , BETA, LMVAL, and the fractional ranks of each
of our four measures of disclosure (i.e., total, annual, other publications,
and investor relations ranks (RTSCR, RANLSCR, ROPBSCR, and RINVSCR,
respectively). Results using Pearson correlations are substantively similar.
A valid measure of the cost of equity capital should be increasing in risk
as measured by market beta and we find a significant positive association
between BETA and rDIV . The mean correlation coefficient is 0.182 and is
significantly different from zero in ten out of eleven years. In addition to
being positively correlated with BETA, the cost of equity capital estimates
should display the well known “size effect.” Consistent with this expectation,
the results documented in table 3 indicate a negative association between
firm size and rDIV . The mean correlation coefficient is −0.073 and is signifi-
cantly negative in six years and significantly positive in one year.11 Table 3
also documents a strong positive association between firm size and each
of the disclosure measures. This finding agrees with prior research (Lang
and Lundholm [1993]). Contrary to our expectation, however, none of
the disclosure measures is consistently negatively correlated with rDIV . This
analysis ignores the potential impact of correlations among the explanatory
variables, however. In the next section of the paper we perform multivariate
analysis to address this issue.

11 We also explore the joint relationship between the cost of equity capital estimates and

BETA and LMVAL using regression analysis. These results are not presented in a table. How-
ever, we find results consistent with our univariate analysis: cost of equity capital is increasing
(decreasing) in market beta (firm size). The magnitude of the coefficient on BETA, an estimate
of the market risk premium on beta, is in the neighborhood of 3%. Based on these tests, we
conclude that our estimates of cost equity capital are associated with traditional measures of
risk in a manner that supports our claim that these estimates are a valid proxy for expected
cost of equity capital.
DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 33
TABLE 3
Correlation Coefficients Between Cost of Equity Capital, Beta, Log of Market Value,
and Disclosure Measures
The table below provides Spearman correlation coefficients. Analysis employing total disclo-
sure ranks are based on 3,618 observations or an average of 329 observations per year. Analysis
employing annual disclosure ranks and other publication ranks are based on 2,706 observa-
tions, or an average of 246 observations per year. Analysis employing investor relations ranks
are based on 2,728 observations, or an average of 248 observations per year. The number of
observations with category disclosure ranks is less than 3,618 because some industry subcom-
mittees do not breakdown the total disclosure rank by disclosure category. The number of
disclosure ranks for the investor relation category slightly exceeds the number of disclosure
ranks for the annual report and other publications categories because the Oil Service and
Drilling Industry Subcommittee did not disclose annual report and other publication ranks
in 1987. Each cell provides the average yearly correlation coefficient; the number of years out
of the eleven-year sample period the correlation coefficient is significantly positive/negative
with a p-value less than 0.10 (in parentheses); and the average number of observations per
year. rDIV is the estimated cost of equity capital derived from the dividend discount formula.
BETA is estimated via the market model using a minimum of 30 monthly returns over the
60 months prior to June of the publication year of the AIMR Report. We estimate the market
model with a value weighted NYSE/AMEX market index return. LMVAL is the natural log of
the market value of common equity on December 31st of the year prior to the publication year
of the AIMR Report. RTSCR (RANLSCR, ROPBSCR, RINVSCR ) is the rank of the total (annual
report, other publications, investor relation) score.

r DIV BETA LMVAL RTSCR RANLSCR ROPBSCR


0.182
BETA (10/0) —
329
−0.073 −0.030
LMVAL (1/6) (0/2) —
329 329
0.0002 0.042 0.208
RTSCR (0/1) (1/0) (11/0) —
329 329 329
0.008 0.018 0.185 0.824
RANLSCR (0/1) (0/0) (11/0) (11/0) —
246 246 246 246
0.021 0.050 0.136 0.791 0.634
ROPBSCR (0/0) (1/0) (7/0) (11/0) (11/0)
246 246 246 246 246 —
0.003 0.020 0.180 0.743 0.499 0.495
RINVSCR (0/3) (0/0) (11/0) (11/0) (11/0) (11/0)
248 248 248 248 246 246

MULTIVARIATE ANALYSIS OF THE ASSOCIATION BETWEEN THE COST


OF EQUITY CAPITAL AND DISCLOSURE LEVEL

Table 4 presents the results of estimating five alternative models that


employ different combinations of the disclosure measures as explanatory
variables. We report the average coefficient obtained from estimating the
regression equations year-by-year and Fama and MacBeth t-statistics for all
34
TABLE 4
OLS Regressions of the Cost of Equity Capital on Beta, Log of Market Value, and Disclosure Rank
The table below provides the average yearly parameter estimates obtained in cross-sectional regressions for years 1986–1996 and Fama and MacBeth [1973]

C . A . BOTOSAN AND M. A . PLUMLEE


intertemporal t-statistics. Model 1 includes the rank of the total disclosure score and is estimated with an average of 329 observations per year (i.e. a total 3,618
observations across the eleven-year period). Model 2 includes the ranks of all three of the individual disclosure categories that comprise the total disclosure
score and is estimated with an average of 246 observations per year (i.e. a total 2,706 observations across the eleven-year period). Models 3–5 include each of
the three types of disclosure individually in turn (annual report, other publications, and investor relations). Model 3 and 4 are estimated with an average of
246 observations per year (i.e. a total 2,706 observations across the eleven-year period). Model 5 is estimated with an average of 248 observations per year (i.e.
a total 2,728 observations across the eleven-year period). The number of observations with category disclosure ranks is less than 3,618 because some industry
subcommittees do not breakdown the total disclosure rank by disclosure category. The number of disclosure ranks for the investor relation category slightly
exceeds the number of disclosure ranks for the annual report and other publications categories because the Oil Service and Drilling Industry Subcommittee
did not disclose annual report and other publication ranks in 1987. BETA is estimated via the market model using a minimum of 30 monthly returns over
the 60 months prior to June of the publication year of the AIMR Report. We estimate the market model with a value weighted NYSE/AMEX market index
return. LMVAL is the natural log of the market value of common equity on December 31st of the year prior to the publication year of the AIMR Report. RTSCR
(RANLSCR, ROPBSCR, RINVSCR) is the rank of the total (annual report, other publications, investor relation) score. Sample size varies across models because
disclosure category ranks (i.e. RANLSCR, ROPBSCR, RINVSCR) are missing for some industries. *, **, *** indicate significant at a p-value of less than 0.10, 0.05
and 0.01, respectively, using a one-tailed test of significance. # indicates more than two standard deviations from zero.

r it = γ0 + γ1 BETAit + γ2 LMVALit + γ3 RDSCR it + εit


Model 1 Model 2 Model 3 Model 4 Model 5
Expected
Sign Coeff t-Stat Coeff t-Stat Coeff t-Stat Coeff t-Stat Coeff t-Stat
Intercept NA 0.216 8.10 0.188 5.74 0.189 5.71 0.189 5.71 0.187 5.60
BETA + 0.030 5.69∗∗∗ 0.034 5.54∗∗∗ 0.034 5.51∗∗∗ 0.034 5.56∗∗∗ 0.034 5.53∗∗∗
LMVAL − −0.006 −3.73∗∗∗ −0.005 −2.36∗∗ −0.005 −2.26∗∗ −0.005 −2.37∗∗ −0.005 −2.30∗∗
RTSCR − 0.003 0.74
RANLSCR − −0.007 −1.95∗∗ 0.000 0.001
ROPBSCR − 0.013 2.46# 0.008 2.42#
RINVSCR − −0.001 −0.16 0.002 0.48
Average N 329 246 246 246 248
Avg. Adj. R2 5.11% 6.26% 6.08% 6.26% 6.39%
DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 35

five models.12 In all models the coefficient on BETA is significantly positive


and its magnitude suggests a market risk premium in the neighborhood of
3.4%. The coefficient on LMVAL is significantly negative in all 5 models and
the coefficient on LMVAL indicates that a one unit increase in firm size as
measured by log of market value is associated with approximately a one-half
percentage point decrease in the cost of equity capital. The direction of
the association between rDIV and BETA and LMVAL is consistent with the
univariate results reported earlier.
Model 1 in table 4 reports the results estimating regression equation (1),
with RDSCR replaced by a measure of total disclosure level (RTSCR). The
coefficient on total disclosure (RTSCR) is not statistically different from
zero. This result is at odds with our expectations and theory, which suggests
that greater disclosure is associated with a lower cost of equity capital. Em-
ploying total disclosure level in the analysis, however, fails to allow for the
possibility that the association between the cost of equity capital and disclo-
sure may vary across different types of disclosure. This possibility is explored
in model 2, which replaces the RDSCR variable in regression equation (1)
with the 3 separate disclosure category ranks (RANLSCR, ROPBSCR, and
RINVSCR).
The results of estimating model 2 show that the sign of the coefficient on
disclosure is indeed a function of disclosure type. The coefficient on annual
report score (RANLSCR) is significantly negative, suggesting that greater
annual report disclosure is associated with a lower cost of equity capital after
controlling for firm size and market beta. This result is stable across years.
The coefficient on RANLSCR is negative in 9 of the 11 years in our sample
period and is consistent with the annual report being an important source
of information to analysts and other investors. This extends the finding in
prior literature of a negative association between disclosure level and the
cost of equity capital for firms with low analyst following to larger, more
heavily followed firms, across a diverse group of industries, over a number
of years.
While greater annual report disclosure is associated with a lower cost of
equity capital, the coefficient on the other publications score (ROPBSCR)
is not significantly negative. To the contrary, the analysis yields a positive co-
efficient on ROPBSCR that is more than two standard deviations from zero

12 The results of a regression pooled across all eleven years and adjusted t-statistics using

Froot’s [1989] procedure provides substantively similar results. Froot’s procedure uses the
residuals from the OLS regression to estimate a nonzero cross-time covariance for each sample
firm. We also use the procedure employed in Abarbanell and Bernard [2000] to adjust the
Fama-Macbeth t-statistics reported in the table. Results using this method are also substantively
similar to those presented in the tables. The Abarbanell-Bernard procedure adjusts the stan-
dard errors used in the Fama-Macbeth calculations for serial correlation in the coefficient
estimates produced by year-by-year regressions. In our data, the time-series coefficients used
in the adjustment are not statistically significant (expect one model, where the coefficient on
RINVSCR was significantly positive), suggesting that time-series correlation in the coefficients
is not a significant concern in this case.
36 C . A . BOTOSAN AND M. A . PLUMLEE

suggesting that a greater level of more timely disclosure is statistically asso-


ciated with a higher cost of equity capital. This result is also stable across
years, with the coefficient on ROPBSCR positive in 9 out of 11 years. In
the next section of the paper, we provide some additional discussion and
interpretation of this unexpected result. Finally, we find no association be-
tween investor relation disclosure level and the cost of equity capital. Using
the category ranks instead of the total disclosure ranks increases the overall
explanatory power of the regressions from 5.11% in model 1 to 6.26% in
model 2, an increase in the adjusted R2 of approximately 22%.
As noted earlier, our three types of disclosure are correlated with each
other. The lowest correlation of 0.495 is between the other publications and
investor relations ranks whereas the highest correlation, 0.634 is between the
annual report and other publications ranks. The correlation among the dis-
closure variables is a double-edged sword. It may induce multi-collinearity,
which may weaken the power of the tests but should not yield a coefficient
with the “incorrect” sign. However, failing to adequately control for other
types of disclosure when evaluating the impact of an alternative disclosure
type on the cost of equity capital may lead to spurious correlation and erro-
neous conclusions.
To examine this issue, we replace RDSCR in regression equation (1) with
each of the three disclosure category variables in separate models. Model 3
employs RANLSCR, model 4 incorporates ROPBSCR, and model 5 uses
RINVSCR as the independent variable measuring disclosure level. The re-
sults of this analysis highlight the importance of adequately controlling for
alternative means of disclosure when examining the association between
disclosure level and the cost of equity capital. For example, the results of
model 3 taken in isolation would suggest that annual report disclosure level
and the cost of equity capital are not related, while the results of model 4
continue to produce a coefficient on ROBSCR that is positive and more than
two standard deviations from zero. The strength of the association between
ROBSCR and cost of equity capital combined with the strong positive corre-
lation between RANLSCR and ROBSCR is apparently sufficient to cause a
severe correlated omitted variables bias in model 3. Consequently, not con-
trolling for ROPBSCR when assessing the association between RANLSCR
and the cost of equity capital leads the researcher to an erroneous conclu-
sion regarding the impact of annual report disclosure level on cost of equity
capital.

ADDITIONAL DISCUSSION OF THE POSITIVE COEFFICIENT ON OTHER


PUBLICATIONS DISCLOSURE
Our finding that greater disclosure in the other publication category is
statistically associated with a higher cost of equity capital is contrary to the
disclosure theory discussed earlier and our hypothesis. However, this finding
is consistent with concerns expressed by financial executives and others
about the effect of timely disclosures (such as quarterly reports, a major
component of this disclosure category) on the cost of equity capital through
DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 37

stock price volatility. For example, The Financial Times (Iskander [May 7,
1999]) reports that
“The French business community is divided on the benefits of quarterly
disclosure. A large number of managers . . . believe the move would foster
short-termism among investors and increase the volatility of share prices (emphasis
added).”

Similar concerns in the United States motivated Don Ritter, a Republican


congressman from Pennsylvania, to introduce a bill in 1992 to revoke the
Securities and Exchange Commission’s authority to require quarterly re-
porting. Congressman Ritter justified the move by claiming it was a means
of reducing pressure on firms to focus on short-term profits over long-term
shareholder value (Ritter [1992]).
Results documented in Bushee and Noe (BN) [2000] also provide ev-
idence consistent with this story. Using AIMR total disclosure scores, BN
find that higher overall disclosure quality tends to reduce future stock re-
turn volatility, by attracting long-term investors to the firm. They also find,
however, that a high level of disclosure can have a detrimental effect, as it also
attracts transient institutions that trade aggressively on short-term earnings
news. They conclude that the volatility-reducing effect of the trading activity
of long-term investors is almost completely offset by the volatility-increasing
effect arising from the trading activities of transient institutional investors.
While BN’s primary reported results are based on total disclosure scores,
they also examine the association between type of institutional investor and
the three categories of disclosure. In footnoted results (BN, page 15) BN
document a significant positive association between the level of transient
institutional investor ownership and the quality of more timely disclosures
and investor relations but not annual report disclosure. These results indi-
cate an institutional investor clientele effect that is a function of the quality
of disclosure in a given category. Moreover, it supports the supposition that
providing greater timely disclosure attracts a greater proportion of transient
institutional investors whose trading activities have a volatility-increasing ef-
fect on stock returns.
SENSITIVITY ANALYSIS
All of our primary analyses are based on the ranks of the disclosure mea-
sures as opposed to the scores themselves, because the AIMR disclosure
scores are an ordinal measure of disclosure level. In contrast, rDIV , BETA,
and LMVAL are cardinal measures and are included in the models in un-
ranked form to take full advantage of the variation in these measures across
firms. We assess the sensitivity of our results to these choices by estimating a
fully ranked specification of model 2, wherein the fractional rank of rDIV is
regressed on the fractional ranks of each of BETA, LMVAL, and the three
measures of disclosure (RANLSCR, ROPBSCR, and RINVSCR).
The results of this analysis differ from those presented in table 4 in two
respects. First, the explanatory power of the rank model is much lower.
The R2 produced by the rank regression is half as large as that reported in
38 C . A . BOTOSAN AND M. A . PLUMLEE

table 4. Second, while the coefficient on RANLSCR is negative in the rank


regression, it is no longer statistically significant.13
It is important to note that ranking the data limits the informativeness of
the measures included in the regression. In addition, the interpretation of
the magnitude of the coefficients is lost. Rank regressions are appropriate
when the values of the measures are uninformative in and of themselves but
act primarily to order the data (this is the case with the disclosure measures),
or when outliers are a significant concern, or when the distribution of the
variables is not normal or is unknown. Since cross-firm variation in rDIV ,
BETA, and LMVAL is potentially informative and the other problems are
not a significant concern, we believe the loss of statistical significance and
reduction in explanatory power discussed in the preceding paragraph are
consistent with a loss of information.
In additional sensitivity analyses, we include in our analysis two variables
with a prior documented association with the cost of equity capital. The
variables are book-to-market (B/M) (measured as the log of book value
divided by stock price) and price momentum (PrMOM) (measured as the
stock’s return from January through June of the same year for which our
other variables are measured).14
Fama and French [1992] document that high B/M firms earn higher ex-
post realized returns than low B/M firms. In addition, Gebhardt, Lee, and
Swaminathan [2001] find that B/M is positively related to their estimate
of expected cost of equity capital. Jegadeesh and Titman [1993] examine
PrMOM and find that past winners (based on returns over the past 3 to
12 months) earn substantially higher returns than past losers. Although
prior research has documented statistical associations between these vari-
ables and the cost of equity capital as measured by realized returns or an
estimate of the expected cost of equity capital, it has not provided a theory-
based explanation for these findings.
We do not include either variable in our primary analysis because of this
lack of a theoretical underpinning and because neither variable is correlated
with disclosure level. As a result, it is unlikely that omitting B/M and PrMOM
from regression equation (1) induces a correlated omitted variable bias with
respect to our disclosure measures.
The results of estimating such a regression equation show that even after
controlling for B/M and PrMOM in addition to BETA and LMVAL the
conclusions drawn from model 2 are unaffected. That is, the cost of equity
capital is negatively associated with RANLSCR, positively associated with
ROPBSCR and not associated with RINVSCR. Consistent with prior research,

13 We also estimated the additional models included in table 4 using ranks instead of the

cardinal measures. The results using ranks in these models were similar to those found when
using ranks for model 2. The explanatory power of the rank models are much lower, and the
coefficients on variables of interest have the same sign as the regressions based on cardinal
measures, though they are not always statistically significant.
14 These measures as formed consistent with variables found in Gebhardt, Lee, and

Swaminathan[2001].
DISCLOSURE LEVEL AND EXPECTED COST OF EQUITY CAPITAL 39

B/M (PrMOM) is positively (negatively) related to the cost of equity capital.


As including these measures increases the overall explanatory power of the
regression to 18.7%, it is clear that each is capturing some aspect of the
expected cost of equity capital not explained by the other variables included
in the model but it does not appear that either captures information risk.

VI. Summary and Conclusions


We examine the effect of total disclosure on the cost of equity capital and
find, contrary to our expectations, that greater total disclosure is not asso-
ciated with a lower cost of equity capital. However, we find that limiting the
analysis to an examination of the association between overall disclosure level
and the cost of equity capital is insufficient, as the relation between disclo-
sure level and cost of equity capital varies by type of disclosure. Moreover, we
find that examining the association between one type of disclosure without
controlling for other types of disclosure may lead to spurious associations
resulting in erroneous conclusions.
Our results indicate that managers of firms that provide greater disclosure
in the annual report benefit in terms of a lower cost of equity capital, amount-
ing to about a 0.7 percentage point difference between the most and least
forthcoming firms. However, greater other publications disclosure (which
is more timely in nature) is associated with a higher cost of equity capital.
The estimated magnitude of the effect is a 1.3 percentage point difference
between the most and least forthcoming firms. Finally, we document no
association between the level of investor relations activities and the cost of
equity capital. Interestingly the results of our analysis provide some support
for managers’ claims that greater disclosure of more timely information in-
creases their cost of equity capital, perhaps through greater stock return
volatility. These claims are in sharp contrast to theoretical models of the re-
lation between the cost of equity capital and disclosure and the bulk of the
empirical research to date. Based on the results of our analysis we suggest
that the conflicting conclusions of both practitioners and theory regarding
the effect of disclosure on the cost of equity capital may have merit. However,
future research directed at explaining the source of the positive association
between the expected cost of equity capital and timely disclosure level is
needed.

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