Mandatory Disclosure Quality, Inside Ownership, and Cost of Capital

John E. Core

Massachusetts Institute of Technology (MIT) – Sloan School of Management

Luzi Hail

University of Pennsylvania – The Wharton School

Rodrigo S. Verdi

Massachusetts Institute of Technology (MIT)

August 25, 2014

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 find that it is also negatively related to the cost of capital. These negative 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, on average, about five to one.

Disclosure Quality, Inside Ownership, and Cost of Capital – Introduction

As discussed in Lambert, Leuz and Verrecchia (2007), disclosure quality could be negatively related to cost of capital due to two separate effects: (i) an information effect in which disclosure reduces the assessed covariance of cash flows (holding the expected cash flows constant), or (ii) a stewardship effect in which disclosure improves managerial alignment with shareholders and therefore increases expected cash flows (holding the assessed covariance of cash flows constant). The stewardship effect is not unique to disclosure, but present in other governance mechanisms that increase managerial alignment such as inside ownership. As a result, these alternative alignment mechanisms potentially reinforce or abate the stewardship effect of disclosure. We test this argument by examining whether inside ownership is negatively associated with the cost of capital and, if included jointly, how inside ownership affects the relation between disclosure and cost of capital. We focus on inside ownership because there is no argument that ownership has an information effect, but it reduces misalignment costs (La Porta et al., 2002). Thus, if we observe a negative relation between inside ownership and the cost of capital, this suggests that misalignment costs affect the cost of capital.

At the same time, a more pronounced negative effect of disclosure on cost of capital after controlling for the stewardship effect of ownership indicates a substitute relation between the two monitoring mechanisms. This interpretation builds on a finding from prior literature—that disclosure quality is negatively related to inside ownership (e.g., La Porta et al., 1998; Leuz, Nanda, and Wysocki, 2003; Haw et al., 2004)—which in turn lets us shed light on the relative magnitude of the direct and indirect effects of disclosure. Since disclosure reduces ownership, and (as we predict) ownership reduces the cost of capital, we predict and find a positive indirect effect of disclosure through ownership. Accordingly, our analysis of the relation between inside ownership and the cost of capital has implications for the documented negative relation between disclosure quality and the cost of capital (e.g., Francis, Khurana, and Pereira, 2005; Hail and Leuz, 2006). Our findings suggest that the direct effect of disclosure is higher than previously reported. That occurs because, without controlling for ownership, the direct effect is offset by a positive relation between disclosure and cost of capital via the link of inside ownership.

Inside Ownership

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