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The Governance Role of AccountingInformation
Pingyang Gao
Chicago Booth
SWUFE Workshop
July 1, 2016
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 1 / 1
A two-part final exam question
1 cash flow: Fj ≡ a + γj η + φj ξj
2 same systematic risk: γ1 = γ2
3 different idiosyncratic risk: φ1 > φ2
Q1: which has a higher cost of capital?a ∆1 = ∆2
b ∆1 > ∆2
Q2: which has a higher implied cost of capital?a ∆1 = ∆2
b ∆1 > ∆2
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 2 / 1
A two-part final exam question
1 cash flow: Fj ≡ a + γj η + φj ξj
2 same systematic risk: γ1 = γ2
3 different idiosyncratic risk: φ1 > φ2
Q1: which has a higher cost of capital?a ∆1 = ∆2
b ∆1 > ∆2
Q2: which has a higher implied cost of capital?a ∆1 = ∆2
b ∆1 > ∆2
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 2 / 1
A two-part final exam question
1 cash flow: Fj ≡ a + γj η + φj ξj
2 same systematic risk: γ1 = γ2
3 different idiosyncratic risk: φ1 > φ2
Q1: which has a higher cost of capital?a ∆1 = ∆2
b ∆1 > ∆2
Q2: which has a higher implied cost of capital?a ∆1 = ∆2
b ∆1 > ∆2
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 2 / 1
A two-part final exam question
1 cash flow: Fj ≡ a + γj η + φj ξj
2 same systematic risk: γ1 = γ2
3 different idiosyncratic risk: φ1 > φ2
Q1: which has a higher cost of capital?a ∆1 = ∆2
b ∆1 > ∆2
Q2: which has a higher implied cost of capital?a ∆1 = ∆2
b ∆1 > ∆2
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 2 / 1
A two-part final exam question
1 cash flow: Fj ≡ a + γj η + φj ξj
2 same systematic risk: γ1 = γ2
3 different idiosyncratic risk: φ1 > φ2
Q1: which has a higher cost of capital?a ∆1 = ∆2
b ∆1 > ∆2
Q2: which has a higher implied cost of capital?a ∆1 = ∆2
b ∆1 > ∆2
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 2 / 1
A two-part final exam question
1 cash flow: Fj ≡ a + γj η + φj ξj
2 same systematic risk: γ1 = γ2
3 different idiosyncratic risk: φ1 > φ2
Q1: which has a higher cost of capital?a ∆1 = ∆2 correct without moral hazard
b ∆1 > ∆2
Q2: which has a higher implied cost of capital?a ∆1 = ∆2
b ∆1 > ∆2
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 2 / 1
A two-part final exam question
1 cash flow: Fj ≡ a + γj η + φj ξj
2 same systematic risk: γ1 = γ2
3 different idiosyncratic risk: φ1 > φ2
Q1: which has a higher cost of capital?a ∆1 = ∆2 correct without moral hazard
b ∆1 > ∆2 correct with moral hazard
Q2: which has a higher implied cost of capital?a ∆1 = ∆2
b ∆1 > ∆2
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 2 / 1
A two-part final exam question
1 cash flow: Fj ≡ a + γj η + φj ξj
2 same systematic risk: γ1 = γ2
3 different idiosyncratic risk: φ1 > φ2
Q1: which has a higher cost of capital?a ∆1 = ∆2 correct without moral hazard
b ∆1 > ∆2 correct with moral hazard
Q2: which has a higher implied cost of capital?a ∆1 = ∆2 correct regardless of moral hazard
b ∆1 > ∆2
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 2 / 1
Main force: risk sharing distortion affects CoC.
Bonding results in concentration of restricted shares sj .
∆j
= (1− sj ) ∗Cost of Capital Implied
in Traded Stocks + sj ∗Cost of Capital Implied
in Restricted Stocks= Invisible
=Firm j’s
CAPM Beta ×Risk Premium of
the Market Portfolio︸ ︷︷ ︸CAPM Cost of Capital
+Risk Premium ofIdiosyncratic Risk
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 3 / 1
Main force: risk sharing distortion affects CoC.
Bonding results in concentration of restricted shares sj .
∆j = (1− sj ) ∗Cost of Capital Implied
in Traded Stocks + sj ∗Cost of Capital Implied
in Restricted Stocks
= Invisible
=Firm j’s
CAPM Beta ×Risk Premium of
the Market Portfolio︸ ︷︷ ︸CAPM Cost of Capital
+Risk Premium ofIdiosyncratic Risk
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 3 / 1
Main force: risk sharing distortion affects CoC.
Bonding results in concentration of restricted shares sj .
∆j = (1− sj ) ∗Cost of Capital Implied
in Traded Stocks + sj ∗Cost of Capital Implied
in Restricted Stocks
= Invisible
=Firm j’s
CAPM Beta ×Risk Premium of
the Market Portfolio︸ ︷︷ ︸CAPM Cost of Capital
+Risk Premium ofIdiosyncratic Risk
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 3 / 1
Main force: risk sharing distortion affects CoC.
Bonding results in concentration of restricted shares sj .
∆j = (1− sj ) ∗Cost of Capital Implied
in Traded Stocks + sj ∗Cost of Capital Implied
in Restricted Stocks
= Invisible
=Firm j’s
CAPM Beta ×Risk Premium of
the Market Portfolio︸ ︷︷ ︸CAPM Cost of Capital
+Risk Premium ofIdiosyncratic Risk
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 3 / 1
Intuition for the wedge
1 Restricted stocks are issued to the manager as bonding.
2 Concentrated idiosyncratic risk is useful for incentives butcostly to the firm.
3 Systematic risk is filtered out for incentives and optimallyshared in the market.
4 Implied CoC from traded shares v.s. the true financingcost to the firm.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 4 / 1
Intuition for the wedge
1 Restricted stocks are issued to the manager as bonding.
2 Concentrated idiosyncratic risk is useful for incentives butcostly to the firm.
3 Systematic risk is filtered out for incentives and optimallyshared in the market.
4 Implied CoC from traded shares v.s. the true financingcost to the firm.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 4 / 1
Intuition for the wedge
1 Restricted stocks are issued to the manager as bonding.
2 Concentrated idiosyncratic risk is useful for incentives butcostly to the firm.
3 Systematic risk is filtered out for incentives and optimallyshared in the market.
4 Implied CoC from traded shares v.s. the true financingcost to the firm.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 4 / 1
Intuition for the wedge
1 Restricted stocks are issued to the manager as bonding.
2 Concentrated idiosyncratic risk is useful for incentives butcostly to the firm.
3 Systematic risk is filtered out for incentives and optimallyshared in the market.
4 Implied CoC from traded shares v.s. the true financingcost to the firm.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 4 / 1
Main results
1 Idio info reduces use of restricted shares and CoC.2 Implied CoC systematically bias downward the true CoC.3 Economy level idio info quality can increase CoC.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 5 / 1
A general equilibrium model with three sub-problems
Moral hazard and optimal compensation contract withineach firm
Personal portfolio management of both managers andinvestorsInvestors’ project selection decisions for each firm
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 7 / 1
A general equilibrium model with three sub-problems
Moral hazard and optimal compensation contract withineach firmPersonal portfolio management of both managers andinvestors
Investors’ project selection decisions for each firm
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 7 / 1
A general equilibrium model with three sub-problems
Moral hazard and optimal compensation contract withineach firmPersonal portfolio management of both managers andinvestorsInvestors’ project selection decisions for each firm
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 7 / 1
The timeline
1 Each investor is endowed with a project, hires a managerwith a compensation package, sells the project, andinvests
2 Each manager receives a contract, chooses an effort, andinvests
3 Projects pay off and all consume.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 8 / 1
The timeline
1 Each investor is endowed with a project, hires a managerwith a compensation package, sells the project, andinvests
2 Each manager receives a contract, chooses an effort, andinvests
3 Projects pay off and all consume.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 8 / 1
The timeline
1 Each investor is endowed with a project, hires a managerwith a compensation package, sells the project, andinvests
2 Each manager receives a contract, chooses an effort, andinvests
3 Projects pay off and all consume.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 8 / 1
The environment
cash flow: Fj ≡ aj − c2a2
j + γj η + φj ξj
accounting signal: Yj = aj + αj εj
contract: wj ≡ vj + bj Yj + sjGj
utility: CE i = E [W i ]− 12ri
Var [W i ], i ∈ I,A.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 9 / 1
The environment
cash flow: Fj ≡ aj − c2a2
j + γj η + φj ξj
accounting signal: Yj = aj + αj εj
contract: wj ≡ vj + bj Yj + sjGj
utility: CE i = E [W i ]− 12ri
Var [W i ], i ∈ I,A.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 9 / 1
The environment
cash flow: Fj ≡ aj − c2a2
j + γj η + φj ξj
accounting signal: Yj = aj + αj εj
contract: wj ≡ vj + bj Yj + sjGj
utility: CE i = E [W i ]− 12ri
Var [W i ], i ∈ I,A.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 9 / 1
The environment
cash flow: Fj ≡ aj − c2a2
j + γj η + φj ξj
accounting signal: Yj = aj + αj εj
contract: wj ≡ vj + bj Yj + sjGj
utility: CE i = E [W i ]− 12ri
Var [W i ], i ∈ I,A.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 9 / 1
Problem 1: moral hazard
The manager chooses an effort.
wj = vj︸︷︷︸Base
Salary
+ bj Yj︸︷︷︸Earnings-based
Bonus
+ sj (Fj − bj Yj )︸ ︷︷ ︸Restricted
Stocks
− c2
a2j︸︷︷︸
EffortCost
+ zj (∫
i∈Ω(1− si )(Fi − bi Yi )di − p)︸ ︷︷ ︸
MarketPortfolio
= (bj + (1− bj )sj )aj −c2
a2j + vj + (E [M ]− p)
= Invisible
+ bj (1− sj )αj ε j︸ ︷︷ ︸Idiosyncratic
Measurement error
+ sj φj ξj︸ ︷︷ ︸Idiosyncratic
Cash Flow Risk
+ (sj γj + zj (Avg[γ]− Avg[rs ]))η︸ ︷︷ ︸Systematic
Cash Flow Risk
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 10 / 1
Problem 1: moral hazard
The manager chooses an effort.
wj = vj︸︷︷︸Base
Salary
+ bj Yj︸︷︷︸Earnings-based
Bonus
+ sj (Fj − bj Yj )︸ ︷︷ ︸Restricted
Stocks
− c2
a2j︸︷︷︸
EffortCost
+ zj (∫
i∈Ω(1− si )(Fi − bi Yi )di − p)︸ ︷︷ ︸
MarketPortfolio
= (bj + (1− bj )sj )aj −c2
a2j + vj + (E [M ]− p)
= Invisible
+ bj (1− sj )αj ε j︸ ︷︷ ︸Idiosyncratic
Measurement error
+ sj φj ξj︸ ︷︷ ︸Idiosyncratic
Cash Flow Risk
+ (sj γj + zj (Avg[γ]− Avg[rs ]))η︸ ︷︷ ︸Systematic
Cash Flow Risk
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 10 / 1
Problem 1: moral hazard
The manager chooses an effort.
wj = vj︸︷︷︸Base
Salary
+ bj Yj︸︷︷︸Earnings-based
Bonus
+ sj (Fj − bj Yj )︸ ︷︷ ︸Restricted
Stocks
− c2
a2j︸︷︷︸
EffortCost
+ zj (∫
i∈Ω(1− si )(Fi − bi Yi )di − p)︸ ︷︷ ︸
MarketPortfolio
= (bj + (1− bj )sj )aj −c2
a2j + vj + (E [M ]− p)
= Invisible
+ bj (1− sj )αj ε j︸ ︷︷ ︸Idiosyncratic
Measurement error
+ sj φj ξj︸ ︷︷ ︸Idiosyncratic
Cash Flow Risk
+ (sj γj + zj (Avg[γ]− Avg[rs ]))η︸ ︷︷ ︸Systematic
Cash Flow Risk
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 10 / 1
Problem 1: moral hazard
The manager chooses an effort.
wj = vj︸︷︷︸Base
Salary
+ bj Yj︸︷︷︸Earnings-based
Bonus
+ sj (Fj − bj Yj )︸ ︷︷ ︸Restricted
Stocks
− c2
a2j︸︷︷︸
EffortCost
+ zj (∫
i∈Ω(1− si )(Fi − bi Yi )di − p)︸ ︷︷ ︸
MarketPortfolio
= (bj + (1− bj )sj )aj −c2
a2j + vj + (E [M ]− p)
= Invisible
+ bj (1− sj )αj ε j︸ ︷︷ ︸Idiosyncratic
Measurement error
+ sj φj ξj︸ ︷︷ ︸Idiosyncratic
Cash Flow Risk
+ (sj γj + zj (Avg[γ]− Avg[rs ]))η︸ ︷︷ ︸Systematic
Cash Flow Risk
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 10 / 1
Solution to Moral Hazard
Incentive Compatible:
bj + sj (1− bj )︸ ︷︷ ︸Marginal Benefit
of Effort
− aj c︸︷︷︸Marginal Cost
of Effort
= 0
Individual Rationality:
vj = w0 +c2
aj2 − (sj + (1− sj )bj )aj︸ ︷︷ ︸
Reimbursement forDirect Cost
+Avg[γ]ρE + ρA
sj γj︸ ︷︷ ︸Compensation forSystematic Risk
+s2
j φ2j + (1− sj )
2b2j α2
j
2ρA︸ ︷︷ ︸Compensation forIdiosyncratic Risk
Manager’s portfolio decision
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 11 / 1
Solution to Moral Hazard
Incentive Compatible:
bj + sj (1− bj )︸ ︷︷ ︸Marginal Benefit
of Effort
− aj c︸︷︷︸Marginal Cost
of Effort
= 0
Individual Rationality:
vj = w0 +c2
aj2 − (sj + (1− sj )bj )aj︸ ︷︷ ︸
Reimbursement forDirect Cost
+Avg[γ]ρE + ρA
sj γj︸ ︷︷ ︸Compensation forSystematic Risk
+s2
j φ2j + (1− sj )
2b2j α2
j
2ρA︸ ︷︷ ︸Compensation forIdiosyncratic Risk
Manager’s portfolio decision
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 11 / 1
Solution to Moral Hazard
Incentive Compatible:
bj + sj (1− bj )︸ ︷︷ ︸Marginal Benefit
of Effort
− aj c︸︷︷︸Marginal Cost
of Effort
= 0
Individual Rationality:
vj = w0 +c2
aj2 − (sj + (1− sj )bj )aj︸ ︷︷ ︸
Reimbursement forDirect Cost
+Avg[γ]ρE + ρA
sj γj︸ ︷︷ ︸Compensation forSystematic Risk
+s2
j φ2j + (1− sj )
2b2j α2
j
2ρA︸ ︷︷ ︸Compensation forIdiosyncratic Risk
Manager’s portfolio decision
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 11 / 1
Problem 2: Portfolio Management
Each investor holds a market portfolio.
xj =Avg[γ]
Avg[γ]− Avg[γs]ρI
ρI + ρA
Manager holds a market portfolio plus restricted shares.The systematic risk in her compensation is hedged away.The idiosyncratic risk in her compensation is not.
zj =Avg[γ]
Avg[γ]− Avg[γs]ρA
ρI + ρA− Avg[γ]
Avg[γ]− Avg[γs]γjsj
Avg[γ]
Price of traded shares pays only for systematic risk.
pj = (1− bj)aj −Avg[γ]ρI + ρA
γj
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 12 / 1
Problem 2: Portfolio Management
Each investor holds a market portfolio.
xj =Avg[γ]
Avg[γ]− Avg[γs]ρI
ρI + ρA
Manager holds a market portfolio plus restricted shares.The systematic risk in her compensation is hedged away.The idiosyncratic risk in her compensation is not.
zj =Avg[γ]
Avg[γ]− Avg[γs]ρA
ρI + ρA− Avg[γ]
Avg[γ]− Avg[γs]γjsj
Avg[γ]
Price of traded shares pays only for systematic risk.
pj = (1− bj)aj −Avg[γ]ρI + ρA
γj
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 12 / 1
Problem 2: Portfolio Management
Each investor holds a market portfolio.
xj =Avg[γ]
Avg[γ]− Avg[γs]ρI
ρI + ρA
Manager holds a market portfolio plus restricted shares.The systematic risk in her compensation is hedged away.The idiosyncratic risk in her compensation is not.
zj =Avg[γ]
Avg[γ]− Avg[γs]ρA
ρI + ρA− Avg[γ]
Avg[γ]− Avg[γs]γjsj
Avg[γ]
Price of traded shares pays only for systematic risk.
pj = (1− bj)aj −Avg[γ]ρI + ρA
γj
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 12 / 1
Problem 2: Portfolio Management
Each investor holds a market portfolio.
xj =Avg[γ]
Avg[γ]− Avg[γs]ρI
ρI + ρA
Manager holds a market portfolio plus restricted shares.The systematic risk in her compensation is hedged away.The idiosyncratic risk in her compensation is not.
zj =Avg[γ]
Avg[γ]− Avg[γs]ρA
ρI + ρA− Avg[γ]
Avg[γ]− Avg[γs]γjsj
Avg[γ]
Price of traded shares pays only for systematic risk.
pj = (1− bj)aj −Avg[γ]ρI + ρA
γj
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 12 / 1
Problem 2: Portfolio Management
Each investor holds a market portfolio.
xj =Avg[γ]
Avg[γ]− Avg[γs]ρI
ρI + ρA
Manager holds a market portfolio plus restricted shares.The systematic risk in her compensation is hedged away.The idiosyncratic risk in her compensation is not.
zj =Avg[γ]
Avg[γ]− Avg[γs]ρA
ρI + ρA− Avg[γ]
Avg[γ]− Avg[γs]γjsj
Avg[γ]
Price of traded shares pays only for systematic risk.
pj = (1− bj)aj −Avg[γ]ρI + ρA
γj
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 12 / 1
Problem 3: optimal contract and financing decisions
The NPV rule for financing: (1− sj)pj − vj − k0
The optimal compensation contract decision:
L(bj , sj , µ) = aj −c2
a2j −
Avg[γ]ρI + ρA
γj −(bj(1− sj))
2α2j + s2
j φ2j
2ρA
+invisible
+2µ(bj + (1− bj)sj − ajc)
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 13 / 1
Problem 3: optimal contract and financing decisions
The NPV rule for financing: (1− sj)pj − vj − k0
The optimal compensation contract decision:
L(bj , sj , µ) = aj −c2
a2j −
Avg[γ]ρI + ρA
γj −(bj(1− sj))
2α2j + s2
j φ2j
2ρA
+invisible
+2µ(bj + (1− bj)sj − ajc)
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 13 / 1
Problem 3: optimal contract and financing decisions
The NPV rule for financing: (1− sj)pj − vj − k0
The optimal compensation contract decision:
L(bj , sj , µ) = aj −c2
a2j −
Avg[γ]ρI + ρA
γj −(bj(1− sj))
2α2j + s2
j φ2j
2ρA
+invisible
+2µ(bj + (1− bj)sj − ajc)
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 13 / 1
Problem 3: optimal contract and financing decisions
The NPV rule for financing: (1− sj)pj − vj − k0
The optimal compensation contract decision:
L(bj , sj , µ) = aj −c2
a2j −
Avg[γ]ρI + ρA
γj −(bj(1− sj))
2α2j + s2
j φ2j
2ρA
+invisible
+2µ(bj + (1− bj)sj − ajc)
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 13 / 1
Main Result 1: Risk Premium of Idiosyncratic Risk
First best without moral hazard: µ = 0 or bj = sj = 0.
Second best with moral hazard: µ > 0 or bj > 0, sj > 0.
Implication for cost of capital:
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ 1
α2j) + c
Risk premium of the idiosyncratic risk is the shadow priceof moral hazard constraint.
Aj ≡ µ =12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 15 / 1
Main Result 1: Risk Premium of Idiosyncratic Risk
First best without moral hazard: µ = 0 or bj = sj = 0.
Second best with moral hazard: µ > 0 or bj > 0, sj > 0.
Implication for cost of capital:
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ 1
α2j) + c
Risk premium of the idiosyncratic risk is the shadow priceof moral hazard constraint.
Aj ≡ µ =12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 15 / 1
Main Result 1: Risk Premium of Idiosyncratic Risk
First best without moral hazard: µ = 0 or bj = sj = 0.
Second best with moral hazard: µ > 0 or bj > 0, sj > 0.
Implication for cost of capital:
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ 1
α2j) + c
Risk premium of the idiosyncratic risk is the shadow priceof moral hazard constraint.
Aj ≡ µ =12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 15 / 1
Main Result 1: Risk Premium of Idiosyncratic Risk
First best without moral hazard: µ = 0 or bj = sj = 0.
Second best with moral hazard: µ > 0 or bj > 0, sj > 0.
Implication for cost of capital:
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ 1
α2j) + c
Risk premium of the idiosyncratic risk is the shadow priceof moral hazard constraint.
Aj ≡ µ =12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 15 / 1
Main Result 1: Risk Premium of Idiosyncratic Risk
First best without moral hazard: µ = 0 or bj = sj = 0.
Second best with moral hazard: µ > 0 or bj > 0, sj > 0.
Implication for cost of capital:
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ 1
α2j) + c
Risk premium of the idiosyncratic risk is the shadow priceof moral hazard constraint.
Aj ≡ µ =12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 15 / 1
Generalizablity of Result 1
Moral hazard is one example of frictions that leads toconcentration of idiosyncratic risk. Other examples:
Adverse selection: Leland and Pyle (1977)
Blockholding and institutional holding
Debt financing
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 16 / 1
Generalizablity of Result 1
Moral hazard is one example of frictions that leads toconcentration of idiosyncratic risk. Other examples:
Adverse selection: Leland and Pyle (1977)
Blockholding and institutional holding
Debt financing
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 16 / 1
Generalizablity of Result 1
Moral hazard is one example of frictions that leads toconcentration of idiosyncratic risk. Other examples:
Adverse selection: Leland and Pyle (1977)
Blockholding and institutional holding
Debt financing
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 16 / 1
Generalizablity of Result 1
Moral hazard is one example of frictions that leads toconcentration of idiosyncratic risk. Other examples:
Adverse selection: Leland and Pyle (1977)
Blockholding and institutional holding
Debt financing
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 16 / 1
Implication 1: Biased Proxy of Cost of Capital
∆j
= (1− sj ) ∗Cost of Capital Implied
in Traded Stocks + sj ∗Cost of Capital Implied
in Restricted Stocks= Invisible
=Firm j’s
CAPM Beta ×Risk Premium of
the Market Portfolio︸ ︷︷ ︸CAPM Cost of Capital
+Risk Premium ofIdiosyncratic Risk
=γj
Avg[γ]Avg2[γ]
ρI + ρA+
12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 17 / 1
Implication 1: Biased Proxy of Cost of Capital
∆j = (1− sj ) ∗Cost of Capital Implied
in Traded Stocks + sj ∗Cost of Capital Implied
in Restricted Stocks
= Invisible
=Firm j’s
CAPM Beta ×Risk Premium of
the Market Portfolio︸ ︷︷ ︸CAPM Cost of Capital
+Risk Premium ofIdiosyncratic Risk
=γj
Avg[γ]Avg2[γ]
ρI + ρA+
12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 17 / 1
Implication 1: Biased Proxy of Cost of Capital
∆j = (1− sj ) ∗Cost of Capital Implied
in Traded Stocks + sj ∗Cost of Capital Implied
in Restricted Stocks
= Invisible
=Firm j’s
CAPM Beta ×Risk Premium of
the Market Portfolio︸ ︷︷ ︸CAPM Cost of Capital
+Risk Premium ofIdiosyncratic Risk
=γj
Avg[γ]Avg2[γ]
ρI + ρA+
12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 17 / 1
Implication 1: Biased Proxy of Cost of Capital
∆j = (1− sj ) ∗Cost of Capital Implied
in Traded Stocks + sj ∗Cost of Capital Implied
in Restricted Stocks
= Invisible
=Firm j’s
CAPM Beta ×Risk Premium of
the Market Portfolio︸ ︷︷ ︸CAPM Cost of Capital
+Risk Premium ofIdiosyncratic Risk
=γj
Avg[γ]Avg2[γ]
ρI + ρA+
12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 17 / 1
Implication 1: Biased Proxy of Cost of Capital
∆j = (1− sj ) ∗Cost of Capital Implied
in Traded Stocks + sj ∗Cost of Capital Implied
in Restricted Stocks
= Invisible
=Firm j’s
CAPM Beta ×Risk Premium of
the Market Portfolio︸ ︷︷ ︸CAPM Cost of Capital
+Risk Premium ofIdiosyncratic Risk
=γj
Avg[γ]Avg2[γ]
ρI + ρA+
12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 17 / 1
Implication 1: the bias
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ 1
α2j) + c
1 True CoC is the weighted average.2 Empirical CoC is inferred from traded shares.3 Bias = Aj =
12
1ρA(
1φ2
j+ 1
α2j)+c
4 All the effects of idiosyncratic risk on CoC are filtered outby the biased proxy of CoC.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 18 / 1
Implication 1: the bias
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ 1
α2j) + c
1 True CoC is the weighted average.
2 Empirical CoC is inferred from traded shares.3 Bias = Aj =
12
1ρA(
1φ2
j+ 1
α2j)+c
4 All the effects of idiosyncratic risk on CoC are filtered outby the biased proxy of CoC.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 18 / 1
Implication 1: the bias
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ 1
α2j) + c
1 True CoC is the weighted average.2 Empirical CoC is inferred from traded shares.
3 Bias = Aj =12
1ρA(
1φ2
j+ 1
α2j)+c
4 All the effects of idiosyncratic risk on CoC are filtered outby the biased proxy of CoC.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 18 / 1
Implication 1: the bias
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ 1
α2j) + c
1 True CoC is the weighted average.2 Empirical CoC is inferred from traded shares.3 Bias = Aj =
12
1ρA(
1φ2
j+ 1
α2j)+c
4 All the effects of idiosyncratic risk on CoC are filtered outby the biased proxy of CoC.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 18 / 1
Implication 1: the bias
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ 1
α2j) + c
1 True CoC is the weighted average.2 Empirical CoC is inferred from traded shares.3 Bias = Aj =
12
1ρA(
1φ2
j+ 1
α2j)+c
4 All the effects of idiosyncratic risk on CoC are filtered outby the biased proxy of CoC.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 18 / 1
Implication 1: how large is the bias?
1 Managerial ownership is one proxy. Aj =φ2
j2ρA
sj
2 Holderness, Kroszner and Sheehan (1999 JF):21.1%,12.4%, (12.2%,4.6%)
3 Fahlenbrach and Stulz (2009 JFE): 22.3%,14.8%
4 Other solutions that lead to concentration of idiosyncraticrisk: Leland and Pyle (1977), blockholders, debt financing
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 19 / 1
Implication 1: how large is the bias?
1 Managerial ownership is one proxy. Aj =φ2
j2ρA
sj
2 Holderness, Kroszner and Sheehan (1999 JF):21.1%,12.4%, (12.2%,4.6%)
3 Fahlenbrach and Stulz (2009 JFE): 22.3%,14.8%
4 Other solutions that lead to concentration of idiosyncraticrisk: Leland and Pyle (1977), blockholders, debt financing
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 19 / 1
Implication 1: how large is the bias?
1 Managerial ownership is one proxy. Aj =φ2
j2ρA
sj
2 Holderness, Kroszner and Sheehan (1999 JF):21.1%,12.4%, (12.2%,4.6%)
3 Fahlenbrach and Stulz (2009 JFE): 22.3%,14.8%
4 Other solutions that lead to concentration of idiosyncraticrisk: Leland and Pyle (1977), blockholders, debt financing
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 19 / 1
Implication 1: how large is the bias?
1 Managerial ownership is one proxy. Aj =φ2
j2ρA
sj
2 Holderness, Kroszner and Sheehan (1999 JF):21.1%,12.4%, (12.2%,4.6%)
3 Fahlenbrach and Stulz (2009 JFE): 22.3%,14.8%
4 Other solutions that lead to concentration of idiosyncraticrisk: Leland and Pyle (1977), blockholders, debt financing
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 19 / 1
Implication 1: remedies
Look for the true CoC: Investment decisions
Ij ∝ d −∆j =12c− k0−w0−
Avg[γ]ρI + ρA
γj −12
1ρA(
1φ2
j+ 1
α2j) + c
Determinants of the bias:
Aj =12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 20 / 1
Implication 1: remedies
Look for the true CoC: Investment decisions
Ij ∝ d −∆j =12c− k0−w0−
Avg[γ]ρI + ρA
γj −12
1ρA(
1φ2
j+ 1
α2j) + c
Determinants of the bias:
Aj =12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 20 / 1
The general equilibrium effects
αj ≡ λj α + δj
firm level quality: δj
economy level quality: α
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 21 / 1
Main Result 2: General Equilibrium Effects ofAccounting Quality
As accounting quality changes in the economy level,
CoC is determined by the market portfolio
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ ( 1
λj α+δj)2) + c
Market portfolio is determined by CoC.
Avg[γ] =∫
∆i<dγidi
CoC could increase or decrease and firms differ.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 22 / 1
Main Result 2: General Equilibrium Effects ofAccounting Quality
As accounting quality changes in the economy level,CoC is determined by the market portfolio
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ ( 1
λj α+δj)2) + c
Market portfolio is determined by CoC.
Avg[γ] =∫
∆i<dγidi
CoC could increase or decrease and firms differ.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 22 / 1
Main Result 2: General Equilibrium Effects ofAccounting Quality
As accounting quality changes in the economy level,CoC is determined by the market portfolio
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ ( 1
λj α+δj)2) + c
Market portfolio is determined by CoC.
Avg[γ] =∫
∆i<dγidi
CoC could increase or decrease and firms differ.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 22 / 1
Main Result 2: General Equilibrium Effects ofAccounting Quality
As accounting quality changes in the economy level,CoC is determined by the market portfolio
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ ( 1
λj α+δj)2) + c
Market portfolio is determined by CoC.
Avg[γ] =∫
∆i<dγidi
CoC could increase or decrease and firms differ.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 22 / 1
Main Result 2: General Equilibrium Effects ofAccounting Quality
As accounting quality changes in the economy level,CoC is determined by the market portfolio
∆j =Avg2[γ]
ρI + ρA
γj
Avg[γ]+
12
1ρA(
1φ2
j+ ( 1
λj α+δj)2) + c
Market portfolio is determined by CoC.
Avg[γ] =∫
∆i<dγidi
CoC could increase or decrease and firms differ.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 22 / 1
Proposition
As the quality of accounting information at the economy-levelimproves (α becomes smaller), for an individual firm:
1 the quality of its accounting information improves;2 the risk premium for its idiosyncratic risk decreases
(∂Aj∂α > 0);
3 the risk premium for its systematic risk (weakly) increases(
γjrI+rA
∂Γ∂α < 0); and
4 the risk premium it pays to finance its project could eitherincrease or decrease, depending on its sensitivity to theeconomy-level factor α and its relative exposure tosystematic and idiosyncratic risk. That is, ∂∆j
∂α > 0 if andonly if − γj
rI+rA
∂Γ∂α <
λj2
∂Aj∂αj
.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 23 / 1
An Example of the General Equilibrium Effect
1 Type 1: λ1 = 0 and γ1 > 0
2 Type 2: λ2 = 0 and γ2 = 3γ1
3 Type 3: λ3 > 0 is large and γ3 = 2γ1
Assumption: 4 γ21
ρI+ρA< d < 9
2γ2
1ρI+ρA
If α=0, Avg[γ] = γ1+2γ12 , None of Type 2 is financed:
∆2 =32 γ1
ρI+ρA∗ (3γ1) > d ;
If α =1, Avg[γ] = γ1, Some of Type 2 are financed:∆2 = γ1
ρI+ρA∗ (3γ1) < d ;
The first and second best cases do not subsume each other.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 24 / 1
An Example of the General Equilibrium Effect
1 Type 1: λ1 = 0 and γ1 > 0
2 Type 2: λ2 = 0 and γ2 = 3γ1
3 Type 3: λ3 > 0 is large and γ3 = 2γ1
Assumption: 4 γ21
ρI+ρA< d < 9
2γ2
1ρI+ρA
If α=0, Avg[γ] = γ1+2γ12 , None of Type 2 is financed:
∆2 =32 γ1
ρI+ρA∗ (3γ1) > d ;
If α =1, Avg[γ] = γ1, Some of Type 2 are financed:∆2 = γ1
ρI+ρA∗ (3γ1) < d ;
The first and second best cases do not subsume each other.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 24 / 1
An Example of the General Equilibrium Effect
1 Type 1: λ1 = 0 and γ1 > 0
2 Type 2: λ2 = 0 and γ2 = 3γ1
3 Type 3: λ3 > 0 is large and γ3 = 2γ1
Assumption: 4 γ21
ρI+ρA< d < 9
2γ2
1ρI+ρA
If α=0, Avg[γ] = γ1+2γ12 , None of Type 2 is financed:
∆2 =32 γ1
ρI+ρA∗ (3γ1) > d ;
If α =1, Avg[γ] = γ1, Some of Type 2 are financed:∆2 = γ1
ρI+ρA∗ (3γ1) < d ;
The first and second best cases do not subsume each other.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 24 / 1
An Example of the General Equilibrium Effect
1 Type 1: λ1 = 0 and γ1 > 0
2 Type 2: λ2 = 0 and γ2 = 3γ1
3 Type 3: λ3 > 0 is large and γ3 = 2γ1
Assumption: 4 γ21
ρI+ρA< d < 9
2γ2
1ρI+ρA
If α=0, Avg[γ] = γ1+2γ12 , None of Type 2 is financed:
∆2 =32 γ1
ρI+ρA∗ (3γ1) > d ;
If α =1, Avg[γ] = γ1, Some of Type 2 are financed:∆2 = γ1
ρI+ρA∗ (3γ1) < d ;
The first and second best cases do not subsume each other.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 24 / 1
An Example of the General Equilibrium Effect
1 Type 1: λ1 = 0 and γ1 > 0
2 Type 2: λ2 = 0 and γ2 = 3γ1
3 Type 3: λ3 > 0 is large and γ3 = 2γ1
Assumption: 4 γ21
ρI+ρA< d < 9
2γ2
1ρI+ρA
If α=0, Avg[γ] = γ1+2γ12 , None of Type 2 is financed:
∆2 =32 γ1
ρI+ρA∗ (3γ1) > d ;
If α =1, Avg[γ] = γ1, Some of Type 2 are financed:∆2 = γ1
ρI+ρA∗ (3γ1) < d ;
The first and second best cases do not subsume each other.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 24 / 1
An Example of the General Equilibrium Effect
1 Type 1: λ1 = 0 and γ1 > 0
2 Type 2: λ2 = 0 and γ2 = 3γ1
3 Type 3: λ3 > 0 is large and γ3 = 2γ1
Assumption: 4 γ21
ρI+ρA< d < 9
2γ2
1ρI+ρA
If α=0, Avg[γ] = γ1+2γ12 , None of Type 2 is financed:
∆2 =32 γ1
ρI+ρA∗ (3γ1) > d ;
If α =1, Avg[γ] = γ1, Some of Type 2 are financed:∆2 = γ1
ρI+ρA∗ (3γ1) < d ;
The first and second best cases do not subsume each other.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 24 / 1
An Example of the General Equilibrium Effect
1 Type 1: λ1 = 0 and γ1 > 0
2 Type 2: λ2 = 0 and γ2 = 3γ1
3 Type 3: λ3 > 0 is large and γ3 = 2γ1
Assumption: 4 γ21
ρI+ρA< d < 9
2γ2
1ρI+ρA
If α=0, Avg[γ] = γ1+2γ12 , None of Type 2 is financed:
∆2 =32 γ1
ρI+ρA∗ (3γ1) > d ;
If α =1, Avg[γ] = γ1, Some of Type 2 are financed:∆2 = γ1
ρI+ρA∗ (3γ1) < d ;
The first and second best cases do not subsume each other.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 24 / 1
General Equilibrium Effect ofIdiosyncratic Accounting Information
SystematicRisk
SSSSSSSSo
Cost ofCapital
- MarketPortfolio
/
IdiosyncraticInformation
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 25 / 1
General Equilibrium Effect ofIdiosyncratic Accounting Information
SystematicRisk
SSSSSSSSo
Cost ofCapital
- MarketPortfolio
/
IdiosyncraticInformation
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 25 / 1
General Equilibrium Effect ofIdiosyncratic Accounting Information
SystematicRisk
SSSSSSSSo
Cost ofCapital
- MarketPortfolio
/
IdiosyncraticInformation
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 25 / 1
General Equilibrium Effect ofIdiosyncratic Accounting Information
SystematicRisk
SSSSSSSSo
Cost ofCapital
- MarketPortfolio
/
IdiosyncraticInformation
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 25 / 1
General Equilibrium Effect ofIdiosyncratic Accounting Information
SystematicRisk
SSSSSSSSo
Cost ofCapital
- MarketPortfolio
/
IdiosyncraticInformation
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 25 / 1
General Equilibrium Effect ofIdiosyncratic Accounting Information
SystematicRisk
SSSSSSSSo
Cost ofCapital
- MarketPortfolio
/
IdiosyncraticInformation
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 25 / 1
General Equilibrium Effect ofIdiosyncratic Accounting Information
SystematicRisk
SSSSSSSSo
Cost ofCapital
- MarketPortfolio
/
IdiosyncraticInformation
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 25 / 1
Implication 2: Accounting Quality is a "Factor"!
∆j =γj
Avg[γ]︸ ︷︷ ︸Firm j’s
CAPM Beta
× Avg2[γ]
ρI + ρA︸ ︷︷ ︸Risk Premium of
the Market Portfolio︸ ︷︷ ︸CAPM Cost of Capital
+ Aj︸︷︷︸Risk Premium ofIdiosyncratic Risk
Aj =12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 26 / 1
Implication 2: Accounting Quality is a "Factor"!
∆j =γj
Avg[γ]︸ ︷︷ ︸Firm j’s
CAPM Beta
× Avg2[γ]
ρI + ρA︸ ︷︷ ︸Risk Premium of
the Market Portfolio︸ ︷︷ ︸CAPM Cost of Capital
+ Aj︸︷︷︸Risk Premium ofIdiosyncratic Risk
Aj =12
1ρA(
1φ2
j+ 1
α2j) + c
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 26 / 1
Implication 3: Testing Effects of Accounting Standardsand Disclosure Regulation
Higher accounting quality for all does not lead to lower CoC forall!
The GE effect, or the externality through market portfolio, hasdistributional consequences.
As accounting quality in the economy-level increases,risk premium of the idiosyncratic risk decreases
risk premium of the market portfolio and beta could eitherincrease or decrease
overall effect on CoC is not clear
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 27 / 1
Implication 3: Testing Effects of Accounting Standardsand Disclosure Regulation
Higher accounting quality for all does not lead to lower CoC forall!
The GE effect, or the externality through market portfolio, hasdistributional consequences.
As accounting quality in the economy-level increases,risk premium of the idiosyncratic risk decreases
risk premium of the market portfolio and beta could eitherincrease or decrease
overall effect on CoC is not clear
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 27 / 1
Implication 3: Testing Effects of Accounting Standardsand Disclosure Regulation
Higher accounting quality for all does not lead to lower CoC forall!
The GE effect, or the externality through market portfolio, hasdistributional consequences.
As accounting quality in the economy-level increases,risk premium of the idiosyncratic risk decreases
risk premium of the market portfolio and beta could eitherincrease or decrease
overall effect on CoC is not clear
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 27 / 1
Implication 3: Testing Effects of Accounting Standardsand Disclosure Regulation
Higher accounting quality for all does not lead to lower CoC forall!
The GE effect, or the externality through market portfolio, hasdistributional consequences.
As accounting quality in the economy-level increases,risk premium of the idiosyncratic risk decreases
risk premium of the market portfolio and beta could eitherincrease or decrease
overall effect on CoC is not clear
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 27 / 1
Implication 3: Testing Effects of Accounting Standardsand Disclosure Regulation
Higher accounting quality for all does not lead to lower CoC forall!
The GE effect, or the externality through market portfolio, hasdistributional consequences.
As accounting quality in the economy-level increases,risk premium of the idiosyncratic risk decreases
risk premium of the market portfolio and beta could eitherincrease or decrease
overall effect on CoC is not clear
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 27 / 1
Take-aways
Idiosyncratic accounting information reduces CoC.
Implied CoC biases downward the true CoC.
Economy-wide accounting quality change hascomplicated general equilibrium effect.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 28 / 1
Take-aways
Idiosyncratic accounting information reduces CoC.
Implied CoC biases downward the true CoC.
Economy-wide accounting quality change hascomplicated general equilibrium effect.
Gao (Chicago Booth) Agency Cost and Cost of Capital Chicago Booth 28 / 1