Cost of Equity Capital, Information Asymmetry, and Segment Disclosure

Abstract

Theory predicts a negative association between the cost of equity capital and the level of financial disclosure of the firm. However, empirical evidence supporting a negative association between the cost of equity capital and the level of disclosure has been mixed (Botosan 1997; Botosan and Plumlee, 2002). Prior literature has not specifically examined the relation between the cost of equity capital and the level of segment disclosure (i.e., operating and geographic segment information). Segment reporting is considered by financial analysts worldwide, to be one of the most important, if not the most important, disclosure in financial reporting. Based on the average of four proxies commonly used to measure the cost of equity capital and a hand-collected index measuring the level of segment disclosures, this study initially finds an insignificant negative association between the cost of equity capital and the level of segment disclosure. However, the model does not consider the effects of information asymmetry between investors measured by the probability of information-based trading. Including the direct and interactive effects of the probability of information-based trading in the model we find: 1) a significant negative association between the cost of equity capital and level of segment disclosure, 2) a significant positive association between the cost of equity capital and the probability of information-based trading, and 3) a significant negative association between the cost of equity capital and the interaction term on the level of segment disclosure and probability of information-based trading. In summary, when the probability of information based trading is high (higher information asymmetry among different types of investors), we find the negative association between the cost of equity capital and the level of segment disclosures is stronger. Consistent results are obtained using two separate measures of the level of segment disclosures; a hand-collected index measuring the level of operating and geographic segment disclosures and a count of the number of words used in reporting overall segment information by the firm.