Disclosure Quality, Cost of Capital, and Investors’ Welfare∗

It is widely believed that disclosure quality improves investors’ welfare by reducing cost of capital in a competitive market. This paper examines this conventional wisdom by studying a production economy in which disclosure influences a firm’s investment decisions. I demonstrate three points. First, cost of capital could increase with disclosure quality when new investment is sufficiently elastic. Second, there are plausible conditions under which disclosure quality reduces the welfare of current and/or new investors. Finally, cost of capital is not a sufficient statistic for the impacts of disclosure quality on the welfare of either current or new investors. These results may help interpret the mixed empirical findings on the relationship between disclosure quality and cost of capital, inform the empirical efforts to measure the economic consequences of accounting disclosure, and add to the ongoing debate on the reform of financial reporting and disclosure regulation. ∗I sincerely thank my advisers, Rick Antle, John Geanakoplos, Brian Mittendorf, and Shyam Sunder (Chair), for their guidance, encouragement, and insights. I also thank Mingcherng Deng, Merle Ederhof, Jonathan Glover, Dong Lou, Jacob Thomas, Robert E. Verrecchia, Xiaoyan Wen, Hongjun Yan, Dae-Hee Yoon, Frank Zhang, Michael Zhang, and Yun Zhang for their helpful comments and suggestions. In addition, I am grateful for the generous financial support of the Deloitte Foundation. †Email: [email protected]