A real effect across time: disclosure quality, cost of capital and profitability

Purpose: In the presence of ‘real effects’ of disclosure in a production economy, this research investigates the link between disclosure and cost of capital relating to different time periods: namely the post-disclosure cost of capital (the cost of capital subsequent to disclosure), the pre-disclosure cost of capital (the cost of capital for the period leading up to disclosure), and the overall cost of capital (the cost of capital across both periods). We also extend our analysis to whether and how in the presence of a real effect of disclosure, investors’ ex-ante welfare might be affected.

Design/methodology/approach: This research is conducted via stylized models.

Findings: We demonstrate that, first, in contrast to findings in a pure-exchange economy, in a production-based economy where disclosure affects firms’ investment decisions, both the overall cost of capital and the investors’ ex-ante welfare can be affected by disclosure quality. As disclosure quality improves, the post-disclosure cost of capital may either increase or decrease, as may the pre-disclosure cost of capital. The change in the post-disclosure cost of capital is not fully offset by the change in the pre-disclosure cost of capital, and therefore the overall cost of capital can either increase or decrease. Second, a firm’s profitability of existing and new production are critical factors in determining whether cost of capital increases or decreases with disclosure quality. We characterize conditions under which higher disclosure quality increases or decreases the disclosing firm’s cost of capital over different time periods. Third, when disclosure affects interrelated firms’ production decisions, the disclosing firm’s overall cost of capital changes with disclosure quality, even when the marginal (unconditional) distribution of the disclosing firm’s cash flow is not affected by the disclosure.

Originality: This research contributes to a largely unexplored but important area: the real effect of disclosure on the cost of capital.