1. 1 Regulation Fair Disclosure and the Cost of Equity Capital Zhihong Chen City University of Hong Kong Dan S. Dhaliwal University of Arizona Hong Xie University of Illinois at Urbana-Champaign

2. 2 Research Question Has Reg FD reduced the cost of capital as the SEC believed?

3. 3 Motivation Reg FD prohibits selective disclosure of material information to a subset of market participants. The SEC is concerned that with selective disclosure individual investors will lose confidence in the integrity of capital markets By curtailing selective disclosure, the SEC believed that Reg FD would “encourage continued widespread investor participation in our markets, enhancing market efficiency and liquidity, and more effective capital raising” (SEC 2000)  i.e., SEC believed that Reg FD could ultimately reduce CoC by leveling the information playing filed.

4. 4 Motivation – continued Recent theory papers (Easley and O’Hara 2004; Hughes et al. 2006; Lambert et al. 2006) suggest that CoC (1) increases in information asymmetry (2) decreases in quality and quantity of information If Reg FD curtails selective disclosure and reduces information asymmetry, theory predicts a decrease in CoC post Reg FD, ceteris paribus. If Reg FD produces a “chilling effect” – deterioration in quality and quantity of firms’ communication, theory predicts an increase in CoC post Reg FD, ceteris paribus.

5. 5 Motivation – continued Prior studies investigating the effect of Reg FD on firms’ information environment produce mixed implications for the effect of Reg FD on CoC. Studies imply a decrease in CoC post Reg FD Eleswarapu et al. 2004; Sunder 2002; Gintschel and Markov 2004; Heflin et al. 2003. Studies imply an increase in CoC post Reg FD Bailey et al. 2003; Irani and Karamanou 2003; Gomes et al. 2006. SIA 2001; AIMR 2001. The effect of Reg FD on CoC is ultimately an empirical question.

6. 6 Hypothesis Development To the extent that Reg FD is effective in curtailing selective disclosure and reducing information asymmetry without a significant adverse effect on overall disclosure quality and quantity, we expect CoC to decrease post Reg FD. Formally, H1: CoC is lower in the post-FD period than pre-FD period on average for the full sample, ceteris paribus. Gomes et al. (2006) find Small firms lose analyst following after Reg FD and are unable to replace lost information production from selective disclosure by increased information production in public channels. Medium and large firms gain analyst following after Reg FD and are able to compensate lost information production from selective disclosures by increased information production in public channels. Formally, H2: The reduction in CoC post FD is mostly due to medium and large firms.

7. 7 Hypothesis Development - continued To the extent that Reg FD curtails selective disclosure, reduction in CoC post Reg FD should be greater for firms with more severe selective disclosure before Reg FD than firms with less severe selective disclosure. Based on prior literature, we identify following firm characteristics indicative of selective disclosure: Lower book-to-market ratios (Smith and Watts 1992; Matsumoto 1999; Hutton 2005) With R&D activities (Gintschel and Markov 2004) High levels of institutional, especially transient institutional, ownership (Ke and Petroni 2004; Ke et al. 2005) Formally, H3: The reduction in CoC post FD is greater for firms with low book- to-market ratios, positive R&D expenses or high levels of institutional, especially transient institutional, ownership, relative to their respective counterparts, ceteris paribus.

8. 8 Research Design Estimates of the implied Cost of Capital. Gebhardt, Lee and Swaminathan (2001) Claus and Thomas (2001) Gode and Mohanram (2003) Advantage of using implied cost of capital Theoretically correct (Dhaliwah et al. (2005)) Attempt to separate cash flows effect and discount rate effect from stock prices (Hail and Leuz (2006)) We use the average of three measures as our proxy for CoC to mitigate measurement errors (Dhaliwah et al. (2005)).

9. 9 Research Design – continued Regression Specification Sample period from June 1998 to March 2002 TranFD = 1 if an observation is from 12/1999 to 9/2000 and zero otherwise. PostFD = 1 if an observation is from 12/2000 to 3/2002 and zero otherwise. H1: β 2 < 0 for the full sample H2: β 2 < 0 mostly due to medium and large firms H3: β 2 more negative for firms with low BTM ratio, positive R&D expenses or high levels of institutional, especially transient institutional, ownership

10. 10 Results – Descriptive Statistics

11. 11 Results – The Effect of Reg FD on the Cost of Capital

12. 12 Results – Cross-Sectional Variation in the Reduction in the Cost of Capital

13. 13 Results – ADRs and Foreign Firms

14. 14 Summary of Sensitivity Checks Repeat tests in Table 4 and Table 5 Additional control for analysts’ forecasts properties Excluding observations followed by less than three analysts. Add annual GNP, unemployment rate, 9/11 dummy to control for confounding events. Excluding NASDAQ firms. Control for percentage of buy recommendations. Use risk premiums as the dependent variables. Different sample periods Use average value of dependent and independent variables in regression Use constant sample Results are qualitatively similar.

15. 15 Conclusions and Contributions The results support that Reg FD has lowered CoC as the SEC believed The cost of capital is decreased in the post-FD period relative to the pre-FD period on average for the full sample (a broad cross- section of firms). The reduction in CoC post Reg FD is significant for medium and large firms but is insignificant for small firms. The reduction in CoC is more pronounced for firms with more severe selective disclosure before Reg FD. We contribute to the literature on the likely effects of Reg FD We also contribute to the literature on the role of legal institutions and securities regulations in affecting CoC. We corroborate Bhattacharya and Daouk (2002) – CoC is lower for firms in countries where insider trading laws are enforced. We complement Hail and Leuz (2006) – CoC is lower for firms in countries with more strict and extensive disclosure requirements.