Capital Structure, Cost of Capital, and Voluntary Disclosures

This paper develops a model of financing that jointly determines a firm’s capital structure, its voluntary disclosure policy, and its cost of capital. Investors who receive securities in return for supplying capital sometimes incur losses when they trade their securities with an informed trader. The firm’s disclosure policy and the structure of its securities determine the information advantage of the informed trader and, hence, the size of investors’ trading losses and the firm’s cost of capital.

We establish a hierarchy of optimal securities and disclosure policies that varies with the volatility of the firm’s cash flows. Debt securities are often optimal, with the form of debt—risk-free, investment grade, or “junk”—varying with the firm’s cash flow volatility. Though the model predicts a negative association between firms’ cost of capital and the extent of information firms disclose, more expansive voluntary disclosure does not cause firms’ cost of capital to decline. Mandatory disclosures alter firms’ voluntary disclosures, their capital structure choices, and their cost of capital.