Firm Specific Information and the Cost of Equity Capital

by Philip G. Berger of the University of Chicago,
Huafeng (Jason) Chen of the University of British Columbia, and
Feng Li of the University of Michigan

January 7, 2006

Abstract: We develop a comprehensive and large-sample measure of a firm's information quality. The measure is the ratio of firm-specific return variation to firm-specific cash-flow variation. Empirical evidence supports the validity of our measure. Using this measure, we find that cost of equity capital decreases by about -0.4% on an annual basis if a firm's information quality increases by one standard deviation. This is consistent with the joint hypotheses that (1) firm-specific stock returns contain economic information as argued by Morck, Yeung, and Yu (2000) and (2) better information quality can lower the cost of equity.

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