Modern Economy, 2011, 2, 589-596
doi:10.4236/me.2011.24066 Published Online September 2011 (
Copyright © 2011 SciRes. ME
Accounting Information and Cost of Capital:
A Theor etical Approach
Nicholas Apergis1*, George Artikis2, Sofia Eleftheriou2, J ohn S o rro s 2
1Department of Banking & Financial Management, University of Piraeus, Piraeus, Greece
2Department of Business Administration, University of Piraeus, Piraeus, Greece
E-mail: {*napergis, gartik, sofelef, sorros}
Received April 12, 2011; revised June 5, 2011; accepted June 15, 2011
The primary goal of this study is to provide a theoretical model that shows explicit solutions for equilibrium
prices and derives the equilibrium required return for the firm’s stock price. In other words, this theoretical
study provides a direct link between accounting information, related to the firm’s reports, and the cost of
capital within an equilibrium setting. Accounting information is judged to be of high value because it affects
the market’s ability to direct firms’ capital allocation choices. The findings showed that an increase in ex-
pected cash flows, coming from improvements in the quality of accounting information, leads to a reduction
in the firm’s cost of capital.
Keywords: Theoretical Model, Accounting Information, Cost of Capital, Stock Returns
1. Introduction and Literature
One of the key decisions a firm has to reach is the fun-
damental determination of its cost of capital. This has a
substantial impact on both the composition of the firm’s
operations and its profitability, since shocks onto antici-
pated cash flows are reflected in the firm’s cost of capital.
Many studies have spent tons of ink coming up with
proposals leading to a lower cost of capital. [1] argue that
it is the environment of a firm, which is described by
many parameters, such as accounting standards, market
microstructure and information coming from the firm’s
reports, that really influences the accounting type of in-
formation that determines the firm’s cost of capital and,
consequently, its stock price.
Accounting information reduces information asymme-
tries, which lead to adverse selection in transaction ac-
tivities in the stock market ([2]) as well as to enhanced
liquidity, which lowers the discounts at which firms must
issue capital ([3]). [4] argue that accounting information
tends to compensate shareholders through stock returns
by reducing their exposure to investment risks. Research
in asset-pricing models has not, so far, modelled explic-
itly the accounting information environment in deter-
mining the firm’s required return, though [5] argue that
more factors other than market risk could be equally re-
sponsible for determining a firm’s financial aggregates,
such as stock returns. Neglecting such a factor, however,
places the concept of market efficiency in serious dispute,
a fact that played a prominent role in the recent global
financial crisis. According to [6], although theoretical
arguments support the view that new accounting infor-
mation leads to changes not only in firm’s stock prices,
but also in the traded volume due to the enhanced effect
of informed traders, the empirical evidence does not
seem supportive to the above argument. [6] finds that
excess returns do change upon the arrival of new ac-
counting information, but only if the new information set
can impact the trading activity, the firm’s ownership
characteristics, and the family-firm status.
This study is an extension of two empirical works by
[7,8] that investigate empirically the impact of account-
ing information on the firm’s cost of capital and, then, on
firm’s stock returns. Their result present that certain ac-
counting information variables, directly related to the
firm’s operation and originated from the firm’s financial
reports, exert a true impact on the cost of capital and,
thus, on firm’s stock returns. While the empirical analy-
sis provides some important results in the relevant litera-
ture, a theoretical model is needed to support those em-
pirical findings. Thus, the primary goal, and the novelty
as well, of this study is to provide a theoretical model
that shows explicit solutions for equilibrium prices and
also derives the equilibrium required return for the firm’s
stock. In other words, it attempts to investigate the link
between accounting information and the firm’s cost of
capital. To the extent that accounting information affects
expected cash flows, it also affects the firm’s costs of
capital. Therefore, this theoretical study will provide a
direct link between accounting information related to the
firm’s reports and the cost of capital (so as between the
cost of capital and firm’s stock returns) within an equi-
librium setting. Accounting information is judged to be
of high value because it affects the market’s ability to
direct firms’ capital allocation choices. Moreover, higher
accounting information improves the coordination be-
tween firms and investors with respect to capital invest-
ment decisions, resulting in an increase in expected cash
flows without a commensurate increase in the firm’s
covariance with the market, which is expected to have a
negative effect on the firm’s cost of capital.
At this point we will attempt to connect the derived
equilibrium stock price to the pieces of accounting in-
formation used in the empirical studies by [7,8] and to
justify their empirical findings. At this point, we explic-
itly mention that emphasis is given on the disclosure of
public information. [9] investigate the separation be-
tween public and private information and their role for
the firm’s cost of capital. They find that private informa-
tion increases the risk to uninformed investors of holding
the firm’s stock, once informed investors are more capa-
ble of shifting their portfolio weights to incorporate new
information. They also determine how in equilibrium the
quantity and quality of information affects asset prices,
leading to cross-sectional differences in firm’s required
returns. In such a framework, an individual firm can in-
fluence its cost of capital by choosing features like its
accounting treatments and market microstructure. Their
explicit suggestion is that more information is better than
no information at all.
Overall, a firm’s information structure affects its stock
return. This dictates that a firm’s cost of capital is influ-
enced by information, providing an important linkage
between asset pricing and the information structure of
corporate securities.
Certain studies have attempted in the past to determine
the role of accounting information. Empirical studies in
the issue suggest that accounting information is nega-
tively associated with the firm’s cost of capital ([10-12]).
One main stream of related literature exemplifies the
role of incomplete information. [13] investigates how the
uncertainty, surrounding the presence of certain assets,
influences capital market equilibrium conditions. Here
the term incomplete is defined in a sense that not all po-
tential investors know about every asset. His results dis-
play that in equilibrium the value of the firm is always
lower under incomplete information conditions, while
better information reduces the rate of return demanded
by investors by improving risk sharing. The same results
are also displayed by [14] through a reduction in estima-
tion risk. However, [15] dispute the mechanism of esti-
mation risk on the grounds that the effect of the investor
base is susceptible to arbitrage, while there is much de-
bate about the diversifiability and pricing of such risk,
while [11] find a negative impact running from account-
ing information and the cost of capital. They find, how-
ever, that the association turns positive if higher levels of
accounting information are caused by higher stock price
volatility. [16] explore the relationship between the role
of strategic disclosures and the cost of equity capital.
Based on theoretical arguments, the association is ex-
pected to be negative, though the empirical analysis is
mixed. Their empirical findings, however, confirm the
above mentioned negative relationship due to the fact
that their innovative model considers explicitly the role
of timely strategic disclosure drawing on standardised
Regulatory News Service (RNS) headings. [17] investi-
gate how new accounting information, concerning the
firm’s leverage level, influences firm’s stock prices.
They find that the impact of such information is an in-
creasing function of debt levels.
An alternative stream of research gives emphasis on
the role of information disclosure by firms. Accounting
information is the key turning private into public infor-
mation. This is the framework in which our study be-
longs. [18], through an equilibrium model, shows that
information production is costly, implying the need for
each investor to expend resources to collect the needed
information. [3] analyze how disclosure affects the will-
ingness of market makers to provide liquidity by invest-
ing in a particular stock. They also show that disclosure
changes the risks to market makers, which in turn in-
duces entry or exit by dealers. [1,19] show that disclo-
sure is affected by insiders and strategic issues, while [20]
use a structural microstructure model, which provides
estimates information-based trading for a large cross
section of stocks. [21] reaches the same conclusions only
if the accounting practices, i.e. those that contribute to
accounting information, are characterized as aggressive.
[22] investigate the influence of accounting information
on individual giving decisions through its impact on
market liquidity and the cost of capital for business enti-
ties. However, their experimental empirical results dis-
play a minimal of such impact. Finally, [23] find that
higher levels of accounting information and disclosure
due to the adoption of IAS lead to higher excess returns,
results that are consistent with the negative impact ac-
counting information exerts on the cost of capital.
Finally, there are liquidity-based models that indirectly
link accounting information and firm’s expected stock
Copyright © 2011 SciRes. ME
Copyright © 2011 SciRes. ME
1expUc c
 
returns. [24] make use of a model in which investors
with different expecting holding periods prefer to trade
assets with different relative spreads since they demand
compensation for those spreads. As a result, expected
stock returns are increasing with spreads. [9] show a
model in which investors demand lower stock returns if
such stocks have greater public and less private informa-
where α > 0 and describes the investor’s tolerance for
risk. This particular utility function has the characteristic
that as risk tolerance becomes unbounded, the utility
function converges asymptotically to risk neutrality, i.e.
lim U(c) = c.
The remainder of this paper is organized as follows.
Section 2 presents the theoretical model and provides
certain comparative static’s. Finally, Section 3 concludes
the paper.
In a perfectly competitive market the market price for
firm j we define the vector Di = {Di1, , DiM} as the
1xM vector of investor’s demand for ownership in M
firms. In other words, Dij displays investor’s i demand
for firm j expressed as a percentage of the total firms. If
now Di
* = {Di1
*, , DiM
*} displays the vector of en-
dowed ownership in firms, i.e. Dij
* displays the inves-
tor’s i endowment in firm j expressed as a percentage of
the total firms. Next, we define P = {P1, , PM} the
vector of firm prices, i.e. Pj displays the price of firm j.
Finally, let Bi and Bi
* be investor i’s demand for a
risk-free bond and his endowment in bonds, respectively.
The problem we are called to solve yields:
2. The Model
2.1. The Firm’s Environment
The equilibrium model we employ is a variation of [18]’s
model and captures the interaction between firms and
investors in equity markets as well as the fundamental
role of accounting information in improving the effi-
ciency of firms’ investment decisions. In such a way,
reporting accounting information has real effects that
determine the firms’ cost of capital. Poor accounting
information leads to misaligned investments, which ra-
tional investors anticipate and price in equilibrium by
discounting firms’ expected cash flows at a higher rate of
max1 exp1,,'
 
w.t.r.t. Di, Bi
or (see Equation (2))
w.t.r.t. Di, Bi
where V is an MxM covariance matrix with the t-thy
term defined as: Cov(cs, ct) and Di and Bi are the control
variables of the system, subject to the following budget
Our model deals with an economy with Mj firms, j = 1,
2, , M and a risk-free rate. Let cj and Pj be the uncer-
tain cash flows of firm j and the market equilibrium price
of firm j, respectively. We define the firm’s j cost of
capital as the rate of return Rj obtained from equating the
price of firm j to its expected cash flows:
The first order condition with respect to the variable Di
pEc R or
Next, we assume that nj shows a measure of account-
ing information which is disclosed by firm j to the firm’s
investors and the market. Our goal, as it was set above, is
to determine whether an increase or decrease in firm’s j
accounting information leads to a corresponding de-
crease or increase in the firm’s j cost of capital.
EcPDCovc c
Since in the aggregate investors have claims to the
cash flows of the entire firm, for each s it must be the
case that:
In the following step, we introduce a perfectly com-
petitive market for firm’s j stocks comprised of Ni inves-
tors, i = 1, 2, , N. Our investors are risk-averse. With-
out the hypothesis of risk aversion, the cost of capital
turns out to be zero. Let also introduce an investor’s util-
ity function, represented by U(c), where c denotes an
amount of cash. Each investor has a negative exponential
utility function, yielding:
Therefore, summing both sides of (3) with respect to i
 
NEc PDCovcc
 js
 
** 2
112 2
max1exp1,,,''12 1'
 
 
Copyright © 2011 SciRes. ME
 
NEc PCovcc
The last expression implies that the stock price for
firm j is defined as:
PEcN Covcc
According to (4), the price for firm j is equivalent to
the one derived from the Capital Asset Pricing Model
(CAPM). According to [25] and assuming that the risk
free rate is zero, the CAPM is a market equilibrium pric-
ing equation that yields the following association be-
tween firm’s stock price and firm’s cash flows:
000 0
jj j
PEcEc PCovcc
where c0 represents the sum of cash flows coming from
all firms in the economy, i.e. the market portfolio, 2
represents the variance of the sum of all cash flows,
while P0 is the sum of the stock price of all firms. Equa-
tion (4) and the above expression together yield:
1PEcN 0
which, in turn, implies:
1Ec PN
The above expression constitutes the price of covari-
ance (or non-diversifiable) risk in the economy. Accord-
ing to the above setting, the price of firm j turns to be:
jj j
PEc NCovcc
, (5)
Equation (5) is equivalent to Fama’s CAPM model as
a market equilibrium pricing equation.
2.2. Cost of Capital
In this section we will attempt to figure out what factors
can influence the firm’s j cost of capital. Our analysis is
totally based on Equation (5) that describes the evolution
of the firm’s j price of stock. To this end, we assume that
firm’s j cash flows are described by:
jj j
cab d
 
where θ denotes a random variable with mean zero and
finite precision of q, π is also a random variable with
mean zero and finite precision of hj, a is an intercept term,
b and d are coefficients associated with the variables θ
and π, respectively. We also assume that the πj’s are un-
correlated across firms. In addition, we assume that
firm’s j cash flows have an element of common variation
across firms through θ and an element of idiosyncratic
variation through πj. This issue captures that industry- or
economy-wide events affect the cash flows of virtually
all firms, while firm-specific or idiosyncratic events only
affect the cash flows of firm j. The latter events are con-
sidered diversifiable and not priced through a CAPM
framework. Within such a setting we get:
js jj
Cov ccCovcc
bbE dE
The term
is considered to be the element
of common variation in firm’s j cash flows with the
market, while the term 21
dh is considered to be the
element of idiosyncratic variation. If we substitute the
whole expression into Equation (5), it yields:
PEcNb bqdh
while the expression for Rj yields as the Equation (6).
According to Equation (6), there are certain factors
leading to the reduction of the firm’s cost of capital:
The decline of the variance in the idiosyncratic
variation in firm’s cash flows, 1/hj,
The decline of the variance in the common variation
in firm’s cash flows with the market, 1/q,
The increase in the shareholder’s base of the econ-
omy or alternatively the increase in the number of
investors who participate in the market, N,
The increase in the risk tolerance of the market, α,
and most crucially,
The increase in the firm’s j expected cash flows.
For satisfying the goal of this research paper, we focus
on the last factor. More specifically, we saw that an in-
crease in expected cash flows affected the firm’s cost of
capital Rj. This occurs because as long as expected cash
flows increase, the price Pj at which the market values
the firm’s stocks increases at a different rate. In other
words, the effect on Rj depends on how fast stock prices
increase relative to expected cash flows, which, in turn,
depends on the remaining parameters of the relevant ex-
pression, i.e. the covariance of the cash flows with the
market or the degree of risk aversion.
 
11 1111
jjjs jjjjs jj
REcPNbbqdhEc bbqdh
 
Copyright © 2011 SciRes. ME
Our next step involves us to determine when and how
an increase or decrease in firm’s accounting information
leads to a corresponding decrease or increase in the
firm’s cost of capital. From the above we yield that an
increase in firm’s accounting information reduces either
the variance in the idiosyncratic variation in firm’s cash
flows or investor’s anticipations about that variance; in
both cases the cost of capital decreases. In other words,
an increase in disclosure of accounting information leads
to lower investor’s uncertainty about the parameters that
matter for a secure pricing of the firm. Thus, in order to
be consistent with the approach followed in [8], we must
identify how the variables used there to proxy accounting
information are related to the firm’s cost of capital. In
Cost of capital and leverage = according to pecking
order behaviour, there exists a negative relationship be-
tween a firm’s financial leverage and its cash flows. In
particular, firms with higher internally generated cash
flows require less debt. Firms with productive invest-
ment opportunities rely first on available cash flows to
meet these financing needs. When such cash flows are
depleted, the firm issues debt. This setting implies that
debt acts as a residual of cash flows. Cross-sectional lev-
erage studies that focus on the above mentioned con-
temporaneous relationship find extremely high support
for such behaviour ([26-29]). Once we get a negative
association between leverage and cash flows, Equation
(6) predicts that there also exists a negative relationship
between cash flows and cost of capital and thus we get a
positive association between leverage and cost of capital
as [8] find.
Cost of capital and interest coverage = [30-32] focus
on the ‘balance-sheet effects’ of cash flow shocks and
argue that investment projects do not absorb a firm’s
entire cash-flow shock and that several competing allo-
cations, such as cash saving and debt reduction, expand
or contract a firm’s potential for investment expenses.
They display that high interest coverage indicates an
inability to obtain debt financing, signalling relatively
severe financial constraints. As a result, high interest
coverage motivates firms to look for alternative financial
sources. Depending on the availability of such alternative
sources, the association between cash flows and interest
coverage is blurred, while [33,34] argue that lower ex-
pected cash flows imply that firms have used those cash
flows to finance their investment projects and are not
motivated to turn to debt issues, thus, experiencing lower
interest coverage. But, through Equation (6), lower cash
flows are associated with a higher cost of capital, imply-
ing that interest coverage and cost of capital are both
negatively associated, as [8] find.
Cost of capital and book values = the association be-
tween cash flows and book values depends heavily on
the size of firms. In particular, [35,36] argue that there
exists a positive association between cash flows and
book values for small firms, while the opposite is true for
large firms.
Cost of capital and price-earnings ratio = in case
when the price-earnings ratio is positively driven by the
future growth of firm’s opportunities ([37,38]), then
higher expected growth implies higher price-earnings
ratios and higher expected cash flows, which, through
Equation (6), lead to lower cost of capital, giving result
to a negative association between price-earnings ratios
and cost of capital as [8] find.
Cost of capital and betas = certain empirical studies
have focused on how cash flows affect the firm’s level of
systematic risk or beta. In studies by [39,40], a negative
relationship is found. The rationale stems from how
variances in dividends affect the timing of a firm’s cash
flows and, therefore, the level of systematic risk obtained
by firm’s potential investors, which, in turn, will affect
the firm’s cost of capital. Recently, [41] show that even
by separating the motivation for paying a dividend from
the immediate impact the dividend itself has on the firm,
there is a clear negative relationship between cash flows
and the systematic risk of the firm. Thus, this negative
relationship, through Equation (6), implies that there also
exists a positive relationship between betas and the cost
of capital as [8] show.
2.3. Earnings Quality and the Cost of Capital
Finally, in this section we will extend the above model to
account for the role of earnings quality. [42] documents a
negative relationship between accruals and financial ag-
gregates, such as stock returns. [43] investigate whether
a higher level of quality for audit disclosures is used as a
signalling mechanism about the future course of stock
prices. Their results display that such higher quality lev-
els of accounting disclosures have a substantial impact
on firms’ expected earnings and, thus, on their stock
market returns. This empirical evidence provides strong
support to the signalling value of audit quality levels. [44]
also confirm that lower quality accounting information
about certain accounting variables, such as accruals and
earnings, undermines market efficiency and generates
asset pricing anomalies. [45] investigate whether im-
provements in accounting information through a higher
quality of announcements regarding accruals can be af-
fected following regulatory interventions targeting the
enhancement of accounting information for the case of
the UK. They find that such an improvement does exist
following the adoption of the FRS3 regulatory frame-
Thus, to display how earnings quality can affect the
firm’s expected cash flows, we will present a case where
each firm j reports on its investment opportunities to the
market. We also assume that investors provide managers
with incentives to maximize the firm’s market value.
Therefore, managers select projects that maximize the
market price, given the firm’s report to the market. In
other words, the quality of earnings affects investment
choice, which, in turn, affects expected cash flows.
The effect of higher earnings quality is to improve the
investment efficiency of the firm, without altering the
firm’s covariance with the market. The idea is that the
firm’s technology determines the covariance of the
firm’s cash flows with the market. Earnings quality sim-
ply affects the efficiency with which the investment pro-
ject is implemented. In other words, what we want to
show is that even when earnings quality is firm specific
and has no effect on the covariance of the firm’s cash
flows, is expected to affect the cost of capital through its
impact on expected cash flows.
In this setting, we assume that the firm’s j cash flows
arise from a process in which an investment of an
amount kj results in cash flow of 2
jji j
where θ and πj are independent, normally distributed
random variables with a mean 0 and precisions of q and
hj, respectively, while bj is a positive, fixed coefficient. kj
is firm’s j investment choice. The term
cb kk
 
k cap-
tures that there are diminishing returns to investment
([46]). We also assume that the πj’s are uncorrelated
across firms.
We define πj as firm’s j earnings per unit of invest-
ment. It is an unknown variable to the market. However,
each firm provides the market with a report, say rj, of its
earnings per unit of investment with some noise. That is:
where the noise εj has a normal distribution with mean 0
and precision nj. Once again, noises across firms are as-
sumed to be uncorrelated.
Let now
Pr represent the price of firm j condi-
tional on a report about earnings: . From
Equation (6) we express
r as:
π12 1
jjjj j
jjj jj
jjjj jjj
kErk bbq
knhn rkbbq
Next, we assume that firm’s j investment choice is to
maximize the firm’s market price conditional on an
earnings report. This particular assumption implies that
the manager’s information about π plays no role; what
really matters is the report to the market. More specifi-
cally, firms’ investment opportunities are not observable
to investors and not contractible. Thus, to overcome pos-
sible agency problems, stockholders provide incentives
to maximize market values. Stock-based compensation is
very common in practice and is widely suggested as a
way to align the interests of managers and stockholders
([47]). To this end, we assume that incentives are a
monotonically increasing function of the firm’s market
Let now assume that kkj represents the investment
choice that maximizes market prices conditional on the
firm’s report. The first order condition of maximizing
Pr with respect to kj yields:
kknhn r
If we substitute the expression for kkj back into the
expression for
r yields:
12 1
jjj jjjjj
PEPrnhnh bbq
 
 
 
Next, let cj(rj) represent the firm’s j cash flows condi-
tional on the firm’s earnings report and an investment
choice kkj, where
EcEc r
. Then:
As a result:
EcEc rnhn h
 
 
In the last step, the expression for the firm’s stock
price and its expected cash flows implies the following
for the firm’s cost of capital:
112 1
jjjjjj j
Rbb qnhnhbb q
Next, through expression (7) we will determine how
changes in earnings quality are associated with changes
in Rj, which is, of course, our last goal here. We consider
an increase in earnings quality of firm j, i.e. an increase
in nj. By taking the derivative of Rj with respect to nj
from expression (7) we yield:
jjjj jjj
dR n
hbb qn hhnbb q
 0
According to the above derivative, an increase in
earnings quality leads to the reduction of cost of capital,
which verifies the findings by Apergis et al. (2010b). In
other words, an increase in earnings quality increases
investment alignment, which, in turn, increases expected
cash flows, while has no effect on the covariance of these
cash flows with the market. Thus, the market equilibrium
price of those cash flows rises faster than the expectation
of those cash flows, and the cost of capital declines.
Copyright © 2011 SciRes. ME
3. Conclusions
This theoretical study developed a simple equilibrium
model to analyze the association between accounting
information and firm’s cost of capital and to verify or not
previous empirical findings by the authors. We charac-
terize asset prices in a market equilibrium setting with
risk-averse investors. The findings showed that, even in a
CAPM world, an increase in expected cash flows, com-
ing from improvements in the quality of accounting in-
formation, leads to a reduction in the firm’s cost of capi-
tal. Overall, the study provides a direct link between ac-
counting information and the cost of capital that does
rely on the fact that accounting information along with
improvements in its quality has real effects on capital
allocation that governs firm’s cost of capital.
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