Public Disclosure and Price Fragility

Abstract

I derive a firm’s optimal public disclosure policy aimed at minimizing its cost of raising capital from the equity market. Following the public disclosure, the institutional investors offer incentive contracts to their buy-side analysts to acquire independent private information. Due to the imperfections in evaluating the analysts' performance, the investors rationally demand less private information following good public news and demand more following bad ones. Heterogeneity in cost of information acquisition implies more demand for private information results in more information asymmetry among the investors. Therefore, the overall effect of more transparency on the cost of capital is ambiguous. Furthermore, depending on the public signal and the information structure of the signals available to the analysts, there is either complementarity or substitutability in private information acquisition among the investors. This strategic complementarity results in price discontinuity in the firm's choice of public message. Therefore, to avoid such sharp price drops, firms optimally smooth their earnings reports, as is empirically observed. Finally, there is a positive relationship between the shareholders' liquidity demand and the firm's level of transparency. It might provide a justification why bigger public firms are more transparent. This setting allows studying the effect of selective disclosure and the recent policy changes on the firm’s cost of capital.