Firm Specific Information and the Cost of Equity Capital

We develop a comprehensive and large-sample measure of a firm’s information quality. The measure is the ratio of firm-specific return variation to firm-specific cash-flow variation. Empirical evidence supports the validity of our measure. Using this measure, we find that cost of equity capital decreases by about -0.4% on an annual basis if a firm’s information quality increases by one standard deviation. This is consistent with the joint hypotheses that (1) firm-specific stock returns contain economic information as argued by Morck, Yeung, and Yu (2000) and (2) better information quality can lower the cost of equity. ∗Berger is from the Graduate School of Business at the University of Chicago, Chen is from the Sauder School of Business at the University of British Columbia, and Li is from the Ross School of Business at the University of Michigan. Berger gratefully acknowledges financial support from the Neubauer Family Faculty Fellows program at the University of Chicago Graduate School of Business. We thank workshop participants at Notre Dame and the 2005 Pacific Northwest Finance Conference for their comments. Any remaining errors are our own.