Mandatory Disclosure Quality, Inside Ownership, and Cost of Capital

Whether mandatory disclosure regulation and insider ownership affect a firm’s cost of capital is an important question in financial economics. In our paper, Mandatory Disclosure Quality, Inside Ownership, and Cost of Capital, which was recently made publicly available on SSRN, we examine this question on a large global sample of more than 10,000 firms across 35 countries.

Theory predict that disclosure regulation is negatively related to the cost of capital due to two separate effects: (i) an information effect in which better disclosure improves investors’ prediction of future cash flows, or (ii) a stewardship effect in which better disclosure improves managerial alignment with shareholders and therefore increases expected cash flows. The stewardship effect is not unique to disclosure, but is also present in other governance mechanisms that increase managerial alignment such as inside ownership. As a result, these alternative alignment mechanisms potentially reinforce or substitute for the stewardship effect of disclosure. We test this argument by examining whether inside ownership is negatively associated with the cost of capital and how inside ownership affects the relation between disclosure and the cost of capital.

To test our hypotheses, we gather a sample of more than 50,000 firm-year observations from 35 countries between 1990 and 2004. We use country-level regulations on disclosure as an arguably exogenous proxy for firm-level disclosure quality. Our proxy for inside ownership is the percentage of shares held by corporate insiders as indicated in Worldscope.

We begin our analyses by confirming the negative direct link between mandatory disclosure quality and cost of capital as shown in prior studies. Next, we examine the role of inside ownership. We find that ownership is negatively related to the cost of capital while at the same time disclosure regulation is negatively related to inside ownership. The interpretation of these relations is twofold: first, increased ownership reduces incentive misalignment and in turn lowers the cost of capital. Second, because mandatory disclosure quality substitutes for inside ownership in monitoring management, better disclosure reduces inside ownership, which in turn increases misalignment costs and cost of capital. The result is a positive indirect effect of disclosure on the cost of capital via the stewardship role of ownership.

In economic terms, the results suggest that the (negative) direct effect of disclosure is on the order of a 40 to 70 basis points reduction in implied cost of capital or realized returns, going from the 25th to the 75th percentile of the disclosure quality index. The indirect effect via inside ownership, on the other hand, is positive and offsets the direct effect by up to 30 basis points. Thus, the relative magnitudes between the direct and indirect effects are on the order of a ratio of, on average, five to one, suggesting that the opposing forces of the incentive alignment effect of disclosure are substantive enough to offset portion of the information effect of disclosure. We confirm these results and relative magnitudes with the systematic cost of capital from Fama and French-style portfolio regressions after sorting on ownership and disclosure regulation.

Our paper contributes to prior work that finds a positive relation between ownership and firm value. Since value is equal to future cash flows discounted by the cost of capital, a positive relation between ownership can result from increases in profitability as well as decreases in cost of capital. Our results suggest that the positive relation between ownership and firm value is at least partially driven by lowering the cost of capital. In addition, we provide evidence of the direct and indirect effects of disclosure on the cost of capital. We show that the direct effect is negative whereas the indirect effect is positive, which attenuates the total negative relation between disclosure quality and the cost of capital. These results let us assess the relative importance of the information effect and the stewardship effect of disclosure on the cost of capital.

The full paper is available for download here.