The Effect of Information on Uncertainty and the Cost of Capital

It is widely held that better financial reporting makes investors more confident in their predictions of future cash flows and reduces their required risk premia. The logic is that more information leads necessarily to more certainty, and hence lower subjective estimates of firm “beta” or covariance with other firms. This is misleading on both counts. Bayesian logic shows that the best available information can often leave decision makers less certain about future events. And for those cases where information indeed brings great certainty, conventional mean‐variance asset‐pricing models imply that more certain estimates of future cash payoffs can sometimes bring a higher cost of capital. This occurs when new or better information leads to sufficiently reduced expected firm payoffs. To properly understand the effect of signal quality on the cost of capital, it is essential to think of what that information says, rather than considering merely its “precision,” or how strongly it says what it says.