Mandatory Disclosure Quality, Inside Ownership, and Cost of Capital

Abstract

This paper examines whether and how inside ownership mediates the relation between disclosure quality and the cost of capital. Both ownership and more transparent reporting have the potential to align incentives between managers and investors thereby reducing systematic risk. Employing a large global sample across 35 countries over the 1990 to 2004 period, we show that country-level disclosure regulation is negatively related to (i) inside ownership, and (ii) firms’ implied cost of capital and realized returns. We then introduce ownership into the cost-of-capital model, and also find a negative relation. These relations extend to the systematic component of the cost of capital, estimated from Fama-French portfolio sorts on ownership and disclosure regulation. Thus, while the direct effect of disclosure on cost of capital is negative, the indirect effect via ownership is positive, consistent with disclosure quality and ownership acting as substitutes. Using path analysis to assess the relative magnitude, our estimates suggest that the direct effect of disclosure quality outweighs the indirect effect by a ratio of about five to one.