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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∗
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
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
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.
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
Firms Observations
4 For completeness we also examine three specifications of equation (1) in which RDSCR
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
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
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
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
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.
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
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).”
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
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