“Good disclosure reduces the cost capital”. Old chestnut? Not any more

It is a perennial question; does offering excellent disclosure have a positive effect on companies’ cost of capital? Despite the fact that regulators often use that as a supporting reason for imposing new obligations companies, there has been little supporting evidence. In the aftermath of the corporate crises of the last few years, regulators – in imposing the raft of new regulations from the Market Abuse Directive to Transparency Directive and the new disclosure rules across Europe and the US - have argued that they are assisting companies’ performance through this new regulation.

Although a link between strict disclosure regulation and firms’ cost of capital seems intuitive, there has been little empirical research showing the benefits of disclosure regulation and increased transparency.

In the study “International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter?”, University of Chicago Graduate School of Business visiting professor Christian Leuz and Luzi Hail of the University of Pennsylvania’s Wharton School address this gap, investigating whether stricter disclosure regulation and stronger legal (and institutional) infrastructures offer tangible benefits to firms in 40 countries. The authors analysed differences in the cost of equity capital for these countries, with “equity capital” defined as the money invested by shareholders of the firm.

Leuz and Hail estimated the cost of capital from 1992 to 2001 for several thousand firms from 40 countries. The study is the first to analyse international cost of capital differences for such a large number of countries and to link them with cross-country differences in regulation mandating and enforcing corporate disclosure.

The authors found that firms from countries with more extensive disclosure requirements, stronger securities regulation, and stricter enforcement mechanisms have a significantly lower cost of capital. They established that the cost of capital of firms in countries whose securities regulation ranks in lowest quarter can be as much as 2 percentage points higher than the cost of capital of firms in countries whose securities regulation ranks in the top quartile.

So all that work by IR professionals and the investment in good disclosure systems seems to be very worthwhile…