Academic journal article International Journal of Business

The Effect of Asymmetric Information on the Cost of Capital

Academic journal article International Journal of Business

The Effect of Asymmetric Information on the Cost of Capital

Article excerpt

ABSTRACT

In this paper we propose a new method to compute the cost of capital in domestic and in international settings. Our formulas show the effect of information costs on the cost of capital and give the conditions under which the domestic and the international approach yield the same results in the presence of this imperfection. Information costs are defined within the context of Merton's (1987) model of capital market equilibrium with incomplete information, CAPMI. We argue that the cost of capital in small countries should be estimated using a global CAPMI rather than a local CAPMI. Our simulation results show that the error on the cost of capital for small firms is greater than the large one.

JEL: G3, G15, G31, G32

Keywords: Cost of capital; Information costs; Local CAPM; Global CAPM

I. INTRODUCTION

Despite the considerable controversies surrounding the capital asset pricing model of Sharpe (1964), most valuation approaches in the USA take the CAPM as given and compute the discount rate for equity cash flows. In small countries, academics mimic US practices and use the CAPM with a broad based local index as a proxy for the home country market portfolio. This is referred to as the local CAPM. In Stulz (1995a), the global CAPM refers to the implementation of the standard CAPM with a broad based global index proxying for the collective wealth of countries with easily accessible capital markets for investors who live in any of these countries.

As it appears in the keynote speech of Stulz (1995b), most computations of the cost of capital use the CAPM applied to individual countries as if capital markets were not integrated. In that speech, the main question is to know whether the cost of capital differ for firms located in different countries. The cost of capital refers to a hurdle rate that a project must earn for owners of a firm not to suffer a wealth loss if the project is taken. The definition of this hurdle rate in the neoclassical sense ignores the presence of agency costs. In this spirit, Stulz (1995b) argues that projects that satisfy the neoclassical hurdle rate can destroy shareholder wealth in firms with high agency costs.

As it is well known, the CAPM assumes costless information. Or, as it appears in Merton's (1987) model of capital market equilibrium with incomplete information, CAPMI, this model can better explain the expected returns and some anomalies in financial markets. The type of incomplete information in Merton's (1987) model has something to do with agency costs. Therefore, using the CAPMI can lead to a better estimation of the cost of capital than the standard CAPM since the CAPMI accounts for shadow costs of incomplete information.

Merton (1987) adopts most of the assumptions of the original CAPM and relaxes the assumption of equal information across investors. Besides, he assumes that investors hold only securities of which they are aware. This assumption is motivated by the observation that portfolios held by actual investors include only a small fraction of all available traded securities. The main distinction between Merton's (1987) model and the standard CAPM is that investors invest only in the securities about which they are "aware". This assumption is referred to as incomplete information. However, the more general implication is that securities markets are segmented. The main intuition behind this result is that the absence of a firm-specific risk component in the CAPM comes about because such risk can be eliminated (through diversification) and is not priced. It appears from Merton's model that the effect of incomplete information on expected returns is greater the higher the firm's specific risk and the higher the weight of the asset in the investor's portfolio. The effect of Merton's non market risk factors on expected returns depend on whether the asset is widely held or not.

The CAPMI can be used in the reexamination of corporate risks under incomplete information and in particular in the computation of the cost of capital as in Bellalah (2001). …

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