Optimal Disclosure as a Trade-off between Capital and Product Market Considerations: Theory and Evidence

We study how firms’ disclosure decisions are related to their existing financing and production policies. We develop a rational expectations model in which a firm trades off the benefits of more precise disclosure in reducing its cost of capital against the costs of more precise disclosure in potentially revealing confidential information to competitors. Using abnormal return variance and trading volume (Beaver 1968) as proxies for disclosure precision, we find correlations consistent with our model. We further exploit three quasi-experiments that exogenously affect three underlying parameters in the model and find evidence consistent with our model’s predictions. Our model suggests several important determinants of firms’ optimal disclosure policies.