Mandatory Disclosure Quality,

Inside Ownership, and Cost of Capital

Preliminary and incomplete
(please do not quote or circulate)
John E. Core*
jcore@wharton.upenn.edu
(215) 898-4821
Luzi Hail
lhail@wharton.upenn.edu
(215) 898-8205
Rodrigo S. Verdi
rverdi@mit.edu
(617) 253-2956

First draft: June 10, 2010

Abstract
This paper examines whether and how inside ownership mediates the relation between disclosure
quality and the cost of capital. Both ownership and more transparent reporting have the potential
to curb managerial misappropriation thereby reducing systematic risk. Employing a large global
sample across 36 countries over the 1990 to 2005 period, we find that country-level disclosure
regulation is significantly negatively related to firms implied cost of capital, realized returns,
and the systematic component of cost of capital from Fama-French portfolio sorts on ownership.
Moreover, disclosure quality is also significantly negatively related to ownership, which, in turn,
negatively relates to cost of capital. Thus, while the direct effect of disclosure on cost of capital
is negative, the indirect effect via ownership is positive, consistent with disclosure quality and
ownership acting as substitutes. Using path analysis to assess the relative magnitude, our
estimates suggest that the direct effect of disclosure quality outweighs the indirect effect by a
ratio of about four to one.
_______________
* Corresponding author. We gratefully acknowledge the financial support of the Wharton School and the MIT Sloan
School of Management.

1.

Introduction
This paper examines (i) whether greater inside ownership is associated with a lower cost

of capital and (ii) whether inside ownership is important in mediating the relation between
disclosure quality and the cost of capital. We predict that both disclosure quality and inside
ownership play an important role in monitoring managerial action and curbing managerial
misappropriation thereby affecting firm value and systematic risk. Extant literature generally
focuses on only one aspect of this relation, and either separately analyzes the direct link between
ownership and firm value, typically measured by Tobins Q (e.g., La Porta et al., 2002; Shleifer
and Wolfenzon, 2002; Doidge, Karolyi, and Stulz, 2004), or between disclosure quality and cost
of capital (e.g., Francis, Khurana, and Pereira, 2005; Hail and Leuz, 2006). Our focus is on the
interrelation between the two, more specifically, on how inside ownership acts as a substitute to
disclosure quality when jointly determining a firms cost of capital.
Ceteris paribus, higher monitoring quality via better disclosures and higher inside
ownership both result in lower misappropriation. Taken together, though, the two serve as
substitutes for each other in curbing misappropriation. When monitoring quality is low (e.g., as a
consequence of low disclosure quality), the potential for misappropriation by management is
high. One way to reduce this effect is to increase managerial ownership, which makes managers
share the cost of their misappropriation, and thus misappropriate less. That is, when disclosure
quality is low, managers in need of outside capital choose high inside ownership in order to
credibly commit to low misappropriation and to maximize the proceeds from the sale of equity.
Since ownership is costly (in terms of risk imposed on the entrepreneur and foregone proceeds
from the offering), increases in monitoring quality have the opposite effect, and reduce the need
for a large ownership stake.

Our hypotheses of a substitute relation between disclosure quality and ownership in part
follows from Lambert et al. (2007), who argue that the cost of capital increases when
misappropriation increases, and suggest a direct and an indirect effect of disclosure quality on
the systematic component of the cost of capital. The direct effect of disclosure stems from a
reduction in the assessed covariances between firm and market returns, while the indirect effect
stems from rendering managerial misappropriation more difficult. Inside ownership, in turn,
along with other corporate governance mechanisms can mediate the indirect effect, in that it
reduces misappropriation. Analysis in Himmelberg et al. (2004) also suggests a negative relation
between ownership and systematic risk due to managerial risk-aversion. Managers, exposed to
idiosyncratic risk, will seek projects with high excess returns relative to their systematic returns
(high NPV projects). In turn, because more of the firms cash flow comes from excess returns
that have no systematic risk, investors value the total cash flows with a lower systematic cost of
capital. This investment distortion gets smaller with improved disclosure quality. By
investigating a structural model linking disclosure quality, inside ownership and cost of capital
we provide evidence of the relative importance of the above direct and indirect effects of
disclosure quality on firms systematic risk.
In our empirical work, we focus on testing the predictions about the systematic
component of the cost of capital, which consistently point to a negative relation with both
ownership and disclosure quality.1 To test our hypotheses, we gather a sample of 51,503 firmyear observations from 36 countries between 1990 and 2005. By using a cross-country sample,

For completeness, we also discuss (but do not explicitly test) the relation between disclosure quality, inside
ownership and non-systematic risk. Conceptually, the direction of the effect is ambiguous. Inside ownership can
increase non-systematic risk due to adverse selection, but can also decrease non-systematic risk due to reduced outof-pocket monitoring costs (e.g., Lombardo and Pagano, 2002; Lambert and Verrecchia, 2010). Furthermore,
empirically, isolating the non-systematic component of the cost of capital is challenging because residual cost of
capital reflects shocks and biases as well as expectations.

we are able to use country-level regulations on disclosure as an arguably exogenous (because

mandatory) measure of firm-level disclosure quality. This way we can focus on modeling
ownership and predicting its relation with the cost of capital. We first show that ownership is
negatively related to country-level disclosure quality and other features of the country-level
corporate governance environment. We also control for firm-level determinants of managerial
entrenchment. When modeling ownership in the cost of capital relation, we employ two different
instrumental variables strategies to mitigate concerns about the potential endogeneity of
ownership. In one of our strategies, we follow the theories discussed above that suggest
ownership and cost of capital are optimized at the time of the initial public offering (IPO).
Next, we examine the role of ownership, and find that it is significantly negatively related
to the cost of capital (as proxied by the implied costs of capital and realized returns). In the
implied cost of capital model, this relation is only present after controlling for country-level
disclosure quality and, across realized returns and implied costs of capital, becomes particularly
pronounced once we allow for the endogenous nature of ownership employing an instrumental
variables approach. This finding is consistent with our hypothesis that increased ownership
reduces misappropriation and thus reduces the cost of capital. The result is also consistent with
the risk aversion theory proposed by Himmelberg et al. (2004). Our analyses further confirm the
negative direct link between mandatory disclosure quality and cost of capital as shown in Hail
and Leuz (2006).
To assess the relative magnitude of the direct and indirect effects of disclosure on the cost
of capital we then conduct a path analysis. In line with Hail and Leuz (2006), the direct effect of
disclosure using implied costs of capital is on the order of a 70 basis points reduction, going from
the 25th to the 75th percentile of the disclosure quality index. Taking this as a baseline, results

from the path analysis suggest that the direct effect represents roughly 125 percent of the total
effect of disclosure. Hence, the indirect effect of disclosure via inside ownership is positive and
offsets the direct effect by about 14 basis points. This follows from greater disclosure quality
reducing ownership, and in turn lower ownership increasing misappropriation and cost of capital.
The total effect of disclosure amounts to a reduction in cost of capital of 56 basis points. Even
though the magnitude of the effects varies substantially depending on the model specification,
the general findings all support the substitute relation between disclosure and ownership.
While the preceding tests focus on the total costs of capital and therefore provide indirect
evidence on the hypothesized relations, our final set of analyses focuses on the determinants of
systematic risk. We estimate the systematic cost of capital using portfolio regressions following
Fama and French (1998). We employ two different ways of portfolio sorts. First, we form
portfolios by intersecting ten groups sorted on disclosure quality with ten groups sorted on the
basis of predicted ownership. Second, we form portfolios by sorting firms within each country
into five groups on the basis of predicted ownership. For both portfolio strategies, we find that
predicted ownership and disclosure quality are negatively and significantly related to the
systematic risk of the portfolio, measured either using realized returns or implied costs of capital.
Path analyses again indicate relative magnitudes of the direct and indirect effects of disclosure
very similar to the firm-year regression analyses.
Our paper contributes to the literature in several ways: First, we predict and show a
negative relation between ownership and systematic cost of capital. This finding is related to
prior work that documents a positive relation between ownership and firm value. Since value is
equal to future cash flows discounted by the cost of capital, a positive relation between
ownership can result from increases in profitability as well as decreases in cost of capital. Our

results suggest that the positive relation between ownership and firm value is at least partially
driven by decreases in the cost of capital.
Second, we provide evidence of the direct and indirect effects of disclosure on the cost of
capital. As such, our work is related to studies that examine the direct link between governance
variables, broadly defined, and the cost of capital (e.g., Garmaise and Liu, 2004; Albuquerque
and Wang, 2008; Ashbaugh-Skaife et al., 2009; Hail and Leuz, 2009). For instance, AshbaughSkaife et al. (2009) use a sample of U.S. firms, and find a negative relation between proxies for
the cost of capital, voluntary disclosure, and governance variables such as ownership. Our study
differs in that our main disclosure variable, defined as mandatory requirements at the countrylevel, is plausibly exogenous, and that we use a structural equation approach to model ownership
as an endogenous function of disclosure quality. In addition, we show that the direct effect is
negative whereas the indirect effect is positive, which attenuates the total negative relation
between disclosure quality and the cost of capital. To the best of our knowledge, this finding has
not been established in the literature.
Finally, we focus on the interaction between inside ownership and information quality in
jointly determining the cost of capital, which has been little investigated in prior literature.
Closest to our work is Himmelberg et al. (2004), who study the relation between investor
protection, inside ownership and the marginal return on capital. Our study differs from theirs in
two important ways: First, Himmelberg et al.s definition of cost of capital is from the managers
point of view and more closely captures project profitability. Our study defines cost of capital as
the expected systematic return required by shareholders. Second, Himmelberg et al. assume no
direct effect of investor protection on cost of capitalit all comes through ownership. In line
with Lambert et al. (2007), we test and find that disclosure quality has an indirect as well as a

direct effect on cost of capital, and thereby are able to shed light on the mechanisms that link
these two constructs.
In Section 2 we develop the hypotheses drawing on the diverse theories linking
disclosure quality, inside ownership and the cost of capital. Section 3 describes the research
design including our proxies of (systematic) costs of capital, the instrumental variables approach
and the path analyses. Section 4 presents the results, and Section 5 concludes.
2.

Hypothesis Development
In this section, we develop detailed predictions on the relation between disclosure quality

and the cost of capital with an emphasis on the mediating effect of inside ownership. Our focus is
on the systematic component of the cost of capital, but we also briefly discuss the relation with
the non-systematic component. Exhibit 1 summarizes our predictions in a structural model.
2.1.

Effects of Disclosure Quality and Inside Ownership on Systematic Risk

Lambert et al. (2007) suggest that disclosure quality can have two direct effects and an

indirect effect on the systematic component of the cost of capital. The first direct effect is in
essence an information effect and the second direct effect is in essence a stewardship effect. The
direct information effect occurs because disclosure quality reduces parameter uncertainty
regarding the estimate of expected returns (e.g., Brown, 1979; Barry and Brown, 1984 and
1985). Specifically, better disclosure improves investors prediction of future cash flows. Since
more of the realization of future cash flows is known, the covariance between the firms cash
flows and the cash flows of stocks in the market portfolio becomes lower, which in turn reduces
firm beta and the cost of capital. This effect is not diversifiable because it is present for all
covariance terms, and hence lowers systematic risk. Empirically, estimation risk predicts a

negative relation between disclosure quality and the cost of capital but does not flow through the
channel of inside ownership. This is illustrated as link L1 in Exhibit 1.
Lambert et al. (2007) also suggest that disclosure can have a second direct (stewardship)
effect on systematic cost of capital by making managerial misappropriation more difficult. The
intuition is a follows. Suppose some of the misappropriation is a fixed amount that is
uncorrelated with cash flows. Then this misappropriation reduces expected cash flows, but has
no effect on the covariance of a firms cash flows (CF) with the market cash flows (CFm). If
disclosure reduces this fixed amount of misappropriation, the covariance of cash flows does not
change, but expected cash flows increase, and so does the firm price (P). The covariance of firm
returns (R) and market returns (Rm) has the following inverse relation with the stock price (see p.
390 of Lambert et al.):
cov( R , Rm ) = cov(

CF CFm
1
,
)=
cov( CF , CFm ) .
P Pm
PPm

(1)

An increase in firm price P due to lower fixed misappropriation therefore reduces equity beta
(assuming the covariance of cash flows is positive). This is illustrated as link L2 in Exhibit 1.
Empirically, both L1 and L2 yield the same negative prediction of the effect of disclosure on cost
of capital.
Given the stewardship effect of disclosure on the cost of capital, corporate governance
mechanisms such as inside ownership (which also serve a stewardship role) will mediate or
substitute for the role of disclosure. In this case, the link between ownership and cost of capital
comes from agency models studying managers trade-off between the private benefits of control
(i.e., misappropriation) and the necessity to raise equity to fund projects (e.g., La Porta et al.,
2002; Shleifer and Wolfenzon, 2002; Doidge, Karolyi, and Stulz, 2004). In essence, in these

papers, the entrepreneur maximizes his ownership share of profits , plus his share s of the
profits he steals, less the costs c of stealing (e.g., p. 1150 in La Porta et al., 2002):
(1-s) +s c(DQ,s).

(2)

In this model, disclosure quality (DQ) makes managerial misappropriation more costly (e.g., by
increasing the probability of detection or the amount of penalties conditional on detection). On
the other hand, when disclosure quality is low, the cost of stealing is low. Since the entrepreneur
internalizes the costs of any amounts he steals when issuing equity, high inside ownership is the
optimal contracting outcome. Thus, inside ownership becomes in essence a substitute for good
disclosure in curbing misappropriation. The links L3 and L6 in Exhibit 1 show this indirect
stewardship effect. The links predict a negative relation between disclosure quality and
ownership, in which poor disclosure quality leads to an increase in ownership. Because an
increase in ownership reduces stealing, there is also a negative relation between inside ownership
and cost of capital. In combination, the two links lead to a positive indirect effect of disclosure
quality on the cost of capital through the channel of ownership.
In addition to disclosure quality, other governance features of the institutional
environment (denoted GOV in Exhibit 1) can affect misappropriation. Similar to disclosure
quality, GOV is expected to have a negative effect on the systematic part of cost of capital, either
directly via link L5 or indirectly via ownership (links L4 and L6 for which we expect negative
signs). Note that GOV can be factors as investor protection and securities regulation that reduce
misappropriation because of implicit or explicit penalties or because they help monitoring, but
also can be negative factors such as inside voting control that increase entrenchment. Thus,
ownership can substitute for other governance factors in lowering misappropriation. For
instance, when legal protection is weak, we expect inside ownership to rise.

Finally, Himmelberg et al. (2004) propose that managers risk aversion can lead to a
second effect of ownership on the cost of capital. In their model, inside ownership serves a
substitute role to monitoring quality. However, because firm managers are under-diversified
(compared to external investors), managers bear not only systematic risk but also idiosyncratic
risk. In order to be compensated for this idiosyncratic risk, managers seek only projects that have
total returns in excess of their systematic risk (i.e., positive NPV projects). Zero-NPV (or low
positive NPV) projects that are desirable from a shareholders perspective are undesirable for
under-diversified managers, and therefore rejected because there is not enough extra return to
compensate managers for idiosyncratic risk. Consistent with their hypothesis, Himmelberg et al.
show a positive relation between inside ownership and the marginal profit of capital, which
they proxy for with a scaled sales-to-capital ratio. This is intuitive, since when managers have
higher cutoffs, they will under-invest and show higher average profitability.
The foregoing is from the perspective of the managers whose risk aversion leads to a
positive relation between ownership and total return to capital. Our focus is on investors
required or systematic rate of return, which leads to a negative relation between ownership and
cost of capital. The intuition is the same as in Eq. (1) from above where managerial
misappropriation results in zero beta negative NPV cash flows that raise beta. Here managers
choices result in zero beta positive NPV cash flows that lower beta. More specifically, suppose a
risk-neutral and a risk-averse manager each offer shares in firms with the same expected
earnings. The risk-neutral manager accepts all projects with positive or zero NPV. On the other
hand, the risk-averse manager only adopts some higher positive NPV projects, due to his higher
cutoff rate, and he rejects some positive NPV projects. Thus, for the risk-averse manager more of
his earnings come from excess returns on capital, which by definition have no systematic risk.

The market thus attaches a lower discount rate to these earnings. Empirically the risk aversion
effect, like misappropriation, predicts a negative relation between inside ownership and the cost
of capital (as shown by link L7).
2.2.

Relation to other Theories of Inside Ownership

Note that, because of different assumptions about whether misappropriation can occur,

our prediction of a negative relation between disclosure quality and ownership is different than
the standard agency models prediction of a positive relation. In the standard agency model, less
noise in a performance measure leads to higher inside ownership, suggesting a positive relation
between disclosure quality and ownership. The difference is that, in the entrepreneurial model
summarized in Eq. (2), disclosure quality refers to the monitoring function, i.e., how costly it
is for the entrepreneur to steal.2 As disclosure quality improves, the entrepreneur can reduce the
risk he has by selling more of the firm to outsiders. In the standard agency model, there is
assumed to be no possibility of misappropriation, and disclosure quality refers to the
performance evaluation function, i.e., the amount of noise in a performance measure. As
disclosure quality improves, the principal provides more incentives (sells more of the firm) to the
manager with the same level of risk.
Finally, we note that our prediction of a negative relation between disclosure quality and
ownership above is similar to the prediction that ownership is higher when uncertainty is higher
(e.g., Demsetz and Lehn, 1985; Smith and Watts, 1992; Prendergast, 2002). This view assumes
that the greater the uncertainty in the operating environment, the more difficult it is for
2

Further, note that the feature of disclosure quality that reduces covariances is improved prediction of cash flows.
The feature of disclosure quality that is important for the model above in Eq. (1) is that it makes managerial
misappropriation more costly (e.g., by increasing the probability of detection or the amount of penalties conditional
on detection). One can imagine that improved prediction of cash flows increases the probability of detection, but one
can also imagine features of accounting systems that increase the probability of detection, but might worsen the
prediction of cash flows (e.g., conservatism).

10

shareholders or the board of directors to know why the project was selected (i.e., to maximize
firm value or to maximize the managers private benefits), even if they know what project was
selected. Thus, in more uncertain environments (i.e., information quality is low), managers must
be given greater ownership to motivate the best choice for shareholders.
2.3.

Effects of Disclosure Quality and Inside Ownership on Non-Systematic Risk

The foregoing predicts effects on the systematic component of the cost of capital.

However, recent analytical and empirical work suggests that when markets are imperfect (e.g.,
smaller and segmented markets), there can be an effect on the non-systematic component of
expected returns due to adverse selection (e.g., Akins et al., 2009; Armstrong et al., 2009;
Lambert and Verrecchia, 2010). Adverse selection is the result of information asymmetry, and it
has a positive (no) effect on idiosyncratic risk when markets are imperfect (perfect).
In the context of our study, this suggests that if we separate countries on a proxy for
market competition, we would expect to see a stronger relation between non-systematic returns
and proxies for information asymmetry in low competition countries. For example, the effects of
disclosure quality (which tends to lower information asymmetry) should be greater in less
competitive markets. Evidence in Hail and Leuz (2006) that the negative direct link between
disclosure regulation and cost of capital is more pronounced or only existent in less developed
markets is consistent with this prediction.
The relation with ownership is more subtle, as high inside ownership can proxy for both
market competition and information asymmetry. High inside ownership can be associated with
reduced market competition, for example, if it reduces the number of outside shareholders. Lack
of competition in turn leads to price protection, and uninformed investors (e.g., retail investors)
will require a higher rate of return for holding stocks. Higher inside ownership can also increase

11

information asymmetry if there is a greater potential for insiders trading on information

advantages. On the other hand, since insiders are committing to a high ownership stake in order
to optimize the cost of capital, it is not clear whether the likelihood of insider trading increases
with ownership. Thus, under the adverse selection view, the link between ownership and nonsystematic cost of capital might be positive.
An alternative link, proposed by Lombardo and Pagano (2002), is that higher disclosure
quality lowers out-of-pocket monitoring costs. If shareholders bear higher monitoring costs when
disclosure is weak, these costs must be reflected in higher expected rates of return. An important
distinction is that here the monitoring costs are part of outside investors cash flows, not part of
the firms cash flows. When, as discussed above and in Lambert et al. (2007), misappropriation
costs affect the firms cash flows (such as proprietary disclosure costs), they manifest in the
systematic component of expected returns. However, when monitoring costs are instead part of
outside investors cash flows, then the additional discount to price is captured in excess returns
(i.e., in excess of standard risk factors). This is analogous to transaction costs such as the
required returns due to bid-ask spreads documented in Amihud and Mendelson (1986). Again,
we expect these effects to be stronger in imperfect markets. At the same time, disclosure quality
can be substituted by other governance factors such as ownership. Hence, we also expect higher
ownership to exercise a disciplining role on managers thereby lowering investors out-of-pocket
costs of monitoring. This results in a negative predicted sign on the relation between ownership
and non-systematic cost. Overall and combining the different views, the relation between inside
ownership and non-systematic risk is ambiguous.

12

2.4.

Empirical Predictions
To summarize, employing the entrepreneur model, we discuss two direct channels in

which disclosure can affect the systematic component of the cost of capitallower estimation
risk and lower managerial misappropriation. Because ownership affects misappropriation, it
arises as a substitute for disclosure in controlling misappropriation. The managerial
misappropriation theory and the risk aversion theory both predict a negative association between
ownership and the systematic part of cost of capital. Because other governance factors also
control misappropriation, they behave similarly to disclosure quality in that they lower
ownership and misappropriation. This suggests the following sequence of testable predictions:
H1: Disclosure quality is negatively related to inside ownership.
H2: Disclosure quality is negatively related to the systematic component of the cost of
capital (direct effect of disclosure).
H3: Inside ownership is negatively related to the systematic component of the cost of
capital.
H4: Disclosure quality is positively related to the systematic component of the cost of
capital through the channel of inside ownership (indirect effect of disclosure).
3.

Research Design
We test our hypothesized relations between mandatory disclosure, inside ownership and

cost of capital in three steps: First, we develop an ownership model in which inside ownership is
a function of country-level disclosure regulation and other firm- and country-level factors.
Second, we estimate a cost of capital model in which proxies for the total cost of capital are
regressed on inside ownership, mandatory disclosure and other determinants. Here we pay
special attention to the endogenous nature of ownership, and attempt to assess the relative
magnitude of the direct and indirect disclosure effects using path analysis. Finally, we compute

13

the systematic component of the cost of capital using Fama and French (1998)-style portfolio
regressions with sorts on predicted ownership.
3.1.

Determinants of Inside Ownership

We proxy for Inside Ownership using a measure of closely held shares which represents

the percentage of shares held by corporate insiders.3 This measure has been widely used in the
past (e.g., La Porta et al., 2002) and is available for a large international cross-section of firms.
On the other hand, the measure is noisy, as it captures not only inside ownership but also shares
held by large blockholders. Since this measure is bounded between 0 and 100 percent, we follow
Demsetz and Lehn (1985) and Himmelberg et al. (1999), and use the logit transformed version of
ownership in the analyses, i.e., ln(x/(1 x)) where x is the raw value. This transformation
improves the empirical properties of the variable by changing it to an unbounded range while at
the same time ensuring that the predicted values from an OLS regression are within 0 and 100
percent.
We model inside ownership as a function of mandatory disclosure (DQ), the
effectiveness of the legal system (GOV), which we use as a summary measure for other
governance mechanisms than disclosure quality in a country, and a set of firm-level and countrylevel control variables Zi. This results in the following regression specification:
= 0 + 1DQ + 2GOV + iZi + u.

(3)

In addition, we include industry and year fixed-effects to account for the unobserved
heterogeneity in inside ownership in a given year or industry. In all our regression analyses, we
cluster the standard errors at the country-level, which explicitly controls for cross-sectional and
time-series dependence within a country.
More specifically, our Inside Ownership variable equals the number of closely held shares by corporate insiders
(Field 05475) divided by the number of common shares outstanding (Field 05301) as defined in Worldscope.

14

Our proxy for mandatory disclosure, Disclosure Regulation, follows Hail and Leuz
(2006) and captures cross-country differences in disclosure requirements in securities offerings.
This variable is computed by La Porta, Lopez-de-Silanes, and Shleifer (2006) based on a
questionnaire distributed to security-law attorneys in 49 countries as of December 2000. The
questionnaire focuses on several aspects of disclosure in security offerings such as prospectus
requirements, directors compensation, ownership structure, inside ownership, related-party
transactions, etc. We measure the quality of the overall the legal system (Legal Quality) by using
the rule of law index developed by La Porta et al. (1997). Not surprisingly, this variable is
positively correlated with Disclosure Regulation, and hence controlling for the quality of the
legal system mitigates concerns that our findings are driven by institutional factors other than
mandatory disclosure. As discussed in Section 2, we expect that both variables, Disclosure
Regulation and Legal Quality, are negatively associated with inside ownership.
Our first set of firm-level control variables follow Himmelberg et al. (1999, 2004). We
expect inside ownership to be a function of log(Sales), the ratio of sales to property, plant and
equipment (Sales/PPE), the ratio of research and development expense to sales (R&D/Sales), and
the volatility of monthly stock returns (Return Variability). Because R&D information is often
missing, we include a binary R&D Indicator, which takes on the value of one for firm-years
without valid R&D information. To account for nonlinearities in the relation between ownership
and size, we also include log(Sales) squared in the model. In addition, following La Porta et al.
(1998), we control for countries wealth by including (the logarithm of) the annual gross
domestic product (GDP). Wealthier nations have more large firms that are widely held. At the
same time, GDP might also capture entrepreneurial wealth, which is an important (unobserved)
determinant of ownership (Bitler, Moskowitz, and Vissing-Jrgensen, 2005).

15

Our dependent variable measures the percentage of cash flow rights held by insiders.
However, it is possible that it also captures managerial entrenchment since the voting rights and
cash flow rights of shares are correlated. In the absence of a perfect proxy for voting rights, we
include three additional firm-level variables to isolate the entrenchment effect. Multiple Shares
indicates the existence of multiple share classes thereby facilitating the separation of ownership
and control. The Payout Ratio, measured as dividends per share divided by earnings per share,
controls for the potential of shareholder expropriation. Finally, we include the number of
analysts issuing earnings forecasts for the firm (Analyst Following) as a proxy for outside
monitoring . For more details on variable measurement, see the notes to Table 2.
3.2.

Determinants of the Cost of Capital

Our second set of tests investigates the relation between the cost of capital, inside

ownership, and mandated disclosure. The baseline regression model is as follows:

COC = 0 + 1 + 2DQ + 3GOV + iXi + ,

(4)

where COC is a proxy for the cost of capital, Xi is a set of control variables, and the other
variables are the same as above. The coefficient 1 measures the effect of ownership on the cost
of capital. As previously discussed, we expect this coefficient to be negative due to
misappropriation or risk aversion. The coefficient 2 reflects the direct effect of disclosure
quality on the cost of capital, and we also expect a negative relation.
We use two proxies for the cost of capital. First, we follow Hail and Leuz (2006) and
employ the average implied cost of capital estimate from four different accounting-based
valuation models, suggested in Claus and Thomas (2001), Gebhardt, Lee, and Swaminathan
(2001), Ohlson and Juettner-Nauroth (2005), and Easton (2004). The basic idea of all four
models is to substitute price and analyst forecasts into a valuation equation and to back out the

16

cost of capital as the internal rate of return that equates current stock price with the expected
future sequence of residual incomes or abnormal earnings.4 Since the estimation of these models
does not rely on a long time series of data and also does not take a stance on market integration,
they are particularly suited for a cross-country setting (e.g., Lee, Ng, and Swaminathan, 2007;
Pstor, Sinha, and Swaminathan, 2008).
Our second cost of capital proxy is realized returns. We compute annualized buy-andhold returns in US$ over the 12-month period starting ten months after the end of the fiscal year.
The use of month +10 after the fiscal year-end is for consistency with our measure of implied
cost of capital, which is measured at month +10. Both our proxies of cost of capital have
advantages and disadvantages and, by testing our hypotheses across two conceptually
independent measures, we show that our results are not driven by the limitations of a particular
variable.
As control variables, we begin by including log(Market Value) and the Book-to-Market
ratio, which act as firm characteristics explaining the cross-section of expected returns (Fama
and French, 1992).5 In addition, when analyzing the implied cost of capital, we control for the
volatility in earnings per share over the last five years (Earnings Variability) and the one-yearahead analyst forecast error (Forecast Bias). These variables are intended to control for biases in
analysts forecasts used to impute the implied cost of capital estimates (Guay et al. 2006;
McInnis, 2009). We further control for Inflation because analyst forecasts are expressed in

More specifically, we obtain financial data from Worldscope, and analyst forecasts and share price information
from I/B/E/S. We require each observation to have a one-year-ahead and a two-year-ahead, non-negative earnings
forecast, and either a long-term growth forecast or a three-year-ahead earnings forecast. We measure financial data
as of the fiscal year end and analyst forecasts and stock prices as of month +10 after the end of the fiscal year. This
allows for the financial information to be publicly available and impounded in price by the time of the cost of capital
imputation. For details on the estimation procedure see the appendix of Hail and Leuz (2006).
5
We note that Lambert et al. (2007) is based on a single-factor CAPM model. Intuitively, though, their predictions
extend to multi-factor models, and we apply them to systematic risk from a multi-factor model including size, bookto-market, etc.

17

nominal terms, and hence reflect expected inflation rates. Finally, in line with the ownership
model, we include the three proxies for managerial entrenchment (i.e., Multiple Shares, Payout
Ratio, and Analyst Following), as well as industry and year fixed-effects throughout the analyses.
See the notes to Table 2 for details on the variable measurement.
3.3.

Path Analysis and Instrumental Variables Approach for Inside Ownership

In order to assess the relative magnitude of the stipulated disclosure effects, we apply

path analysis and build on the structural model depicted in Exhibit 1. The direct effect of
disclosure quality is estimated by the coefficient 2 from the cost of capital model in Eq. (4). We
predict 2 to be negative. We compute the indirect effect of disclosure as the effect of disclosure
quality on ownership (1 in Eq. 3) multiplied by the effect of ownership on cost of capital (1 in
Eq. 4). Since both coefficients are hypothesized to assume a negative sign, the indirect effect
should become positive (11 > 0). We expect the direct effect to outweigh the indirect effect so
that the total effect of an increase in disclosure quality is negative ((2 + 11) < 0).
We address the potential endogeneity of ownership by utilizing , the predicted level of
inside ownership, from Eq. (3). This allows us to correct for a biased 1 estimate if ownership is
endogenous, for instance, when we compute the indirect effect of disclosure quality (11). The
instrumental variable also helps allay concerns that if ownership is significant, it is not simply
due to a simultaneity bias. However, finding valid instruments for ownership is a non-trivial
exercise (e.g., Larcker and Rusticus, 2010). Our structural model suggests that any variable
related to monitoring quality or the scope of misappropriation simultaneously affects ownership
and cost of capital, and therefore should be included in both models. What this leaves us with
potential instruments are firm characteristics such as volatility and manager-specific

18

characteristics such as wealth, risk-aversion, and honesty. Yet, the manager characteristics are
difficult to observe. We attempt to address this challenge in two ways.
First, we split our determinants of inside ownership into measures for the volatility of a
risk-averse managers stake in the firm versus measures for the scope of misappropriation. More
specifically, we treat Sales/PP, R&D/Sales, Return Variability and countries GDP as
instruments based on the idea that they more likely capture innate firm volatility, managerial risk
aversion, and managerial wealth. We treat the remaining firm-level determinants (Sales, Multiple
Shares, Payout Ratio, and Analyst Following) as controls for monitoring and entrenchment that
can also affect the cost of capital.
Second, we follow La Porta et al. (2002) and assume that ownership is optimized at the
time of the initial offering of shares (IPO). Thus, while ownership is admittedly endogenous at
that point, it is arguably exogenous to the cost of capital in subsequent years. La Porta et al.
justify this assumption as follows (p. 1165):
Our defense of this assumption is that, generally speaking, ownership patterns are
extremely stable, especially outside the United States, and are shaped largely by histories
of the companies and their founding families.
We then set our determinants of ownership equal to the actual realizations of these variables in
the first year a firm enters the sample (our proxy for the IPO year), and subsequently eliminate
this first year from the analyses when estimating the effect of predicted ownership on the cost of
capital.
3.4.

Systematic Cost of Capital Using Fama-French Portfolio Sorts

A shortcoming of the cost-of-capital regressions in Eq. (4) is that it is unclear whether a

significant coefficient on DQ means lower systematic or non-systematic risk. Specifically,

because we include size and book-to-market as controls for systematic risk, the interpretation of

19

the coefficient on disclosure quality is dependent on how well these controls capture systematic
risk. In this section we describe how we estimate the systematic component of the cost of capital
so that we can form more precise tests of our predictions for the effect of inside ownership.
We compute systematic cost of capital using portfolio level regressions on Fama and
French (1998) factors after sorting on predicted ownership. The main advantage of the portfolio
methodology is that firm-level estimates of factor loadings are noisy (Fama and Macbeth, 1970).
By grouping firms into portfolios we increase the precision of our estimates of systematic risk.
The potential downside of this approach is that it reduces the cross-sectional variation in
ownership to the variation across portfolios.
The portfolio analysis proceeds as follows. Based on the predicted ownership values from
Eq. (3), we conduct two different sorts. In the first, we rank and sort firms independently into ten
groups on the basis of disclosure quality and into ten groups on the basis of predicted ownership.
We then form portfolios based on the intersection. This results in 84 disclosure qualityownership portfolios with at least 60 monthly return observations out of 100 possible portfolios
(ten times ten). The 16 empty portfolios (on the off-diagonal) reflect the negative correlation
between disclosure quality and ownership. In the second sort, we rank and sort firms within each
country into five groups on the basis of predicted ownership. We again require each of these
country-ownership portfolios to contain at least 60 monthly return observations, resulting in 171
portfolios. In both cases, we perform the sorts each year, so that a firm may move across
portfolios as its predicted ownership changes.
We form portfolios in October of each year t+1.6 We match twelve months of stock
returns to each firm-year and, on a monthly basis, compute returns to an equal-weighted portfolio

We choose October because most of our firms have a December fiscal year end. This timing is consistent with the
timing of our measure of implied cost of capital, which is measured at month +10.

20

with annual rebalancing (i.e., a buy-and-hold portfolio). We use equal weights because our
hypotheses are about the expected returns for a typical or average stock. We rebalance annually
to mitigate concerns that frequent rebalancing of an equal-weight portfolio can produce biased
estimates of realized returns due to the bid-ask bounce (Blume and Stambaugh, 1983). We then
estimate the following time-series regression for each portfolio:
RP,t - RF,t = ap + b1,p (RM,t - RF,t) + b2,p HMLt + p,t.

(5)

where RP,t is the portfolio return, RF,t is the return on a one-month U.S. Treasury Bill, RM,t is a
value-weighted world market return from Datastream, and HMLt is the Fama and French (1998)
value-weighted global book-to-market factor. Fama and French (1998, p. 1975) show that the
above two-factor model captures the value premium in international returns. Next, we
calculate the systematic risk of the portfolio using the fitted coefficients b1, p and b2, p .
Specifically, we estimate the following:

Sys RET = b1, p RM + b2, p HML ,

(6)

In Eq. (6) RM and HML are the average values of RM,t and HML for our full sample period.7
The foregoing approach uses the average values of RM,t and HML as estimates of the
global market and HML expected risk premiums. In our firm-year analysis above, we use both
implied cost of capital estimates and realized returns as proxies for the cost of capital. Arguments
in Elton (1999) and others suggest that realized returns can provide noisy estimates of expected
risk premiums, which can be partially addressed by using implied cost of capital. We therefore
re-calculate Eq. (6) using average implied cost of capital estimates (ICC) as proxies of the
expected risk premiums:
7

One way to derive the non-systematic risk of the portfolio is to compute the difference between the average return
of the portfolio and SysRET. However, this residual not only reflects idiosyncratic components but also short-term
shocks, biases and changes in expectations.

21

Sys ICC = b1, p RM , ICC + b2, p HML ICC .8

4.

Results

4.1.

Sample Selection and Description

(7)

Our sample consists of all firms with available data on Worldscope. Following Hail and
Leuz, we eliminate firm-years (1) if there are less than five observations for the country in that
year, (2) if the inflation rate for the country in that year is above 25%, and (3) if we do not have
institutional data for the country. In addition, we require all firms to have information on inside
ownership, cost of capital, mandated disclosure and the control variables. The final sample
consists of 51,503 firm-year observations from 36 countries between 1990 and 2005.
Table 1 provides descriptive statistics on the number of observations, the cost of capital,
inside ownership, mandated disclosure and other country-level institutional factors across all
countries in our sample. The average cost of capital (realized returns) in our sample equals
10.93% (13.53%) when measured with the implied cost of capital (realized returns). The implied
cost of capital varies from an average of 8% in Japan to 17% in Sri Lanka. The average inside
ownership equals 30%, with a large cross-sectional variation (about 20% in the U.K. and U.S. to
more than 70% in the Philippines). Table 2 presents descriptive statistics on the variables used in
the analyses.

We calculate the average ICC risk premia analogous to Fama-French (1998). Specifically, RM , ICC is the average

annual ICC market expected return, and we calculate the ICC market expected return for the year as the valueweighted ICC for all firms in the Fama-French countries for which we have ICC that year. To create the HML
expected premium using ICC, we form book-to-market (BM) deciles by sorting firms in the Fama-French countries
each year on BM. We then calculate the HML expected return each year as the difference between the valueweighted ICC firms in the three highest BM deciles and the value-weighted ICC for the sample firms in the three
lowest BM deciles. HML ICC is the average annual HML expected return.

22

4.2.

Determinants of Inside Ownership

Table 3 presents regressions of for determinants of inside ownership. In all columns, we

follow Demsetz and Lehn (1985) and Himmelberg et al. (1999) and use the logit-transformed
dependent variable ln(ownership/(1-ownership)). The first column presents a model without our
test variables - disclosure and legal quality. The coefficients on log(Sales) and log(Sales)2
suggest a concave relation between sales and ownership that is decreasing except for small
values of sales. This result is consistent with better monitoring for larger firms. It is also
consistent with larger firms having higher shareholder protection which reduces the likelihood of
managerial misappropriation. Inside ownership is positively associated with the sales to capital
ratio (although the coefficients are often insignificant). To the extent that this measure is a proxy
for (the inverse of) asset tangibility, it suggests that ownership is lower when there are more
fixed assets. Firms reporting R&D have also higher inside ownership. However, controlling for
the existence of R&D, more R&D is associated with lower ownership. As discussed in
Himmelberg et al. (2004), one possible explanation for this (counter-intuitive) result is that firms
with higher R&D intensity might be more exposed to idiosyncratic risk, which reduces the
incentives for inside ownership. There is a somewhat unexpected positive sign on stock return
volatility. The positive association suggests that volatility may not proxy for risk that lowers
inside ownership, but for uncertainty and monitoring difficulty that increases inside ownership.
Finally, firms in countries with higher GDP have lower inside ownership.
As for the remaining control variables, insiders of firms with multiple shares hold more
equity. This is consistent with multiple shares capturing agency problems of managerial
entrenchment. The coefficients on payout ratio and analyst following are negative and
significant, consistent with these variables proxying for increased monitoring, reduced agency

23

problems, and reduced need for managerial alignment. The explanatory power of the model in
Column (1) is 24%.
The second column adds our proxies for mandated disclosure quality and the
effectiveness of the law system as additional explanatory variables. The estimated coefficients on
these variables are negative and significant consistent with our predictions and with the results in
La Porta et al. (1998). These results are consistent with the idea that inside ownership
concentration serves as a substitute mechanism to prevent managers and large shareholders from
expropriating outside/minority shareholders. The explanatory power of the model increases to
27%. In model (3) we replace disclosure quality by country fixed-effects. This model serves as a
benchmark as inside ownership is explained using within country explanatory variables in
conjunction with a fixed-effect for each country. The explanatory power of the model equals
37% suggesting that there is still country-level variation unexplained in our full model. In model
(4) we measure all determinants of ownership as of the first year with available data (our proxy
for the IPO year). The estimated coefficients and the explanatory power of the model are largely
consistent with the main model in Eq. (3).
Finally, in column (5), we aggregate the firm-year observations into 386 country-year
observations by computing medians. For binary indicator variables (e.g., multiple shares) we
compute the country-year means instead. We require at least 10 firm-year observations for a
given country and year to be included in the country-year analysis. The estimated coefficients are
largely consistent with the main model in Eq. (3).

4.3.

Determinants of the Cost of Capital

Table 4, Panel A presents the results on the determinants of the cost of capital proxied by

the implied cost of capital. The first model predicts cost of capital as a function of inside

24

ownership and risk controls, without controlling for mandated disclosure. With respect to the risk
and other controls, the results are similar to Hail and Leuz (2006). Cost of capital is negatively
related to firm size and positively associated with book-to-market. Also consistent with Hail and
Leuz (2006), the cost of capital is positively associated with inflation, earnings variability and
forecast bias. As for inside ownership, we find no relation between inside ownership and the
implied cost of capital. A possible explanation for this result for ownership is that while we
predict the direct effect of ownership to be negative, the indirect effect through monitoring
quality is expected to be positive. Without controlling for proxies for monitoring quality, these
two forces have opposing forces. We turn to this next.
The next two columns add country controls, first by country fixed-effects (column (2)),
and second by mandated disclosure and legal quality (column (3)). In both cases, inside
ownership is negatively related to the cost of capital, consistent with the misalignment theory in
which increased ownership increases the alignment between insiders and shareholders and thus
reduces the cost of capital. This result is also consistent with the risk aversion theory proposed
by Himmelberg et al. (2004). Column (3) also shows, consistent with Hail and Leuz (2006), that
disclosure quality and the effectiveness of the legal system are negatively related to the cost of
capital.
In column (4) we decompose inside ownership into the predicted and the residual
component using our full inside ownership model presented in Table 3 Column (2). This
decomposition has two purposes: First, predicted ownership is similar (but not identical) to the
variable used in our 2SLS specification (the distinction is that 2SLS includes the second-stage
controls as explanatory variables in the first stage). Second, by decomposing ownership we can
assess the appropriateness of our ownership model since we have no prediction for the relation

25

between the ownership residual and the cost of capital. We find that predicted ownership is
negatively associated with the cost of capital, whereas the ownership residual is only weakly
related (t-statistic of 1.55) with the cost of capital.
In the next columns (5) to (7) we present the results from two-stage-least-squares (2SLS)
regressions. In column (5), we use as instruments for inside ownership the explanatory variables
in column (2) of table (3). The results are consistent with the OLS estimates: Inside ownership
continues to be negatively associated with the cost of capital. The next column uses the IPO
model in column (4) of table (3) to estimate predicted ownership. The results are generally
similar to the ones presented in column (5). This suggests that inside ownership, when assumed
to be optimized at the IPO date, is negatively associated with implied cost of capital.9 Finally, in
column (8), we show OLS results when we aggregate the firm-year observations into 386
country-year observations by computing medians. The estimated coefficients are largely
consistent with those shown for the other regressions.
Panel B presents the results for the determinants of the cost of capital proxied by realized
returns. With respect to the risk controls, realized returns are negatively related to firm size and
positively associated with book-to-market, consistent with Fama and French (1992). In contrast
to the implied cost of capital results, inside ownership is generally not statistically associated
with realized returns when using OLS estimates. Inside ownership is only negatively related to
realized returns either when decomposed into predicted and residual ownership or in the 2SLS
specification. However, in all these cases, we find a consistent negatively relation between
predicted inside ownership and future realized returns. Further, mandated disclosure and legal
9

In untabulated analysis, we conduct tests suggested by Larcker and Rusticus (2010) when using 2SLS
methodology. We estimate the partial F-statistic for the set of instruments in the first stage. We find a F-statistic of
19.92, which compares to the value of 15.09 suggested by Larcker and Rusticus (p. 192) when using five
instruments. This suggests that our instruments, if valid, are less likely to suffer from the weak instrument
problem.

26

quality are not consistently negative and significant as predicted, and as we find with implied
cost of capital.

4.4.

Path Analysis
Table 5 presents the results of the path analysis, which we use to compute the direct and

indirect effects of disclosure on the cost of capital. To facilitate the computation, we first reestimate our regressions using standardized coefficients. (Standardized coefficients are obtained
by standardizing all of the regression variables to a mean of zero and variance of one.)10 Then,
we estimate the direct effect of disclosure as the coefficient of disclosure on the cost of capital
(2 in Eq. 4). The indirect effect is the product of the coefficient on disclosure in the ownership
model with the coefficient of ownership in the cost of capital model ((11) in Eq. 3 and 4). The
total effect ((11) + 2) is then the sum of the direct and indirect effect.
Panel A presents the analysis for the implied cost of capital. The direct effect equals 0.057 in the OLS specification and -0.126 in the 2SLS specification. Since the standard deviation
of the implied cost of capital is 3.53%, the OLS (2SLS) estimate suggests a 21 (44) basis point
decrease in the cost of capital for a one standard increase in disclosure quality. The indirect
effect, on the other hand, is a positive effect of 0.01 (=-0.235*-0.049) in the OLS specification
and 0.067 (-0.201*-0.334) in the 2SLS regression. This is consistent with a substitute relation
between disclosure and ownership. Specifically, an increase in disclosure is associated with a
reduction in ownership. However, because reduced ownership increases the cost of capital, the
indirect effect is that higher disclosure increases the cost of capital via ownership. The total
effect equals -0.047 in the OLS model and -0.059 in the 2SLS model. Thus, the OLS (2SLS)

10

Equivalently, the path coefficients may be obtained by multiplying regression coefficients by the ratio of the
standard deviation of the dependent variable to the standard deviation of the regressor (Bushee and Noe, 2000).

27

estimate suggests a 16 (21) basis point net decrease in the cost of capital for a one standard
increase in disclosure quality (after accounting for the indirect effect).
Panel B repeats the analysis with realized returns. In this case, the direct effect equals
0.01 in the OLS specification and -0.055 in the 2SLS specification. The indirect effect equals
0.001 (=-0.235*-0.005) in the OLS specification and 0.056 (-0.201*-0.244) in the 2SLS
regression. As for the total effect, it equals 0.011 in the OLS model and 0.001 in the 2SLS
model.
Overall, we find, consistent with the prediction in Lambert et al. (1997), that disclosure
quality has a direct effect on the cost of capital. In addition, we show that the indirect effect is
positive, which attenuates the total negative relation between disclosure quality and the cost of
capital. In fact, while the total effect continues to be negative when using implied cost of capital,
it has a zero net effect with realized returns. To the best of our knowledge, this finding has not
been established in the literature.

4.5.

Determinants of Systematic Risk Using Fama-French Portfolio Sorts

Table 6 presents the results on the determinants of the systematic component of the cost

of capital. We estimate the beta coefficients on the world market portfolio and on the world
HML portfolio using portfolio level regressions of Eq. (5) above. We estimate the cost of capital
by multiplying the beta coefficients with the average sample risk premia. Panel A and Panel B
use Eq. (6) and Eq. (7) with average realized returns and implied costs of capital, respectively, to
estimate systematic part of the cost of capital.
The first two columns of each panel report results for 84 portfolios formed when we rank
and sort firms independently into ten groups on the basis of disclosure quality and into ten
groups on the basis of predicted ownership. We compute our test variables by averaging

28

predicted ownership, disclosure regulation, and legal quality for each portfolio over the time
period of each portfolio.11 Column (1) shows results for the test variables only. Consistent with
our hypothesis, ownership is significantly negatively related to systematic risk. Disclosure
regulation and legal quality are also negative and significant. Results using systematic risk
computed with realized returns are qualitatively similar, although the standard errors are lower
and the R2 is higher with the implied cost of capital, consistent with less noise in the implied cost
of capital.
In column (2), we add controls for entrenchment (period averages for multiple shares,
payout ratio, and analyst following), and, in Panel B, controls for biases in the implied cost of
capital (period averages for inflation, forecast bias, and earnings variability). The entrenchment
controls are insignificant in Panel A, but are significant with the expected signs in Panel B. As
above, and consistent with an entrenchment interpretation, the cost of capital is positively
associated with multiple shares, and is negatively associated with payout ratio and analyst
following. Forecast bias is significant, but with an opposite sign to that of Table 4.
The third and fourth columns of each panel report results for 171 portfolios formed when
we sort firms within each country into five groups on the basis of predicted ownership. The
results in these columns are in general weaker than those in columns (1) and (2). In column (3)
of both panels, consistent with our hypothesis, ownership is significantly negatively related to
systematic risk. Although legal quality is negative and significant in both panels, disclosure
regulation is not. This perhaps reflects our sort design, which generates more variation in
ownership than it does in disclosure regulation. None of the entrenchment controls are significant
in either panel.

11

We require portfolios to have 60 months (five years) of data. Most portfolios have 180 months (15 years) of data.

29

Panel C presents a path analysis of the results in Panels A and B. We base the path
analysis on the regression models without controls (columns (1) and (3)) of Panels A and B.
Again, we first re-estimate our regressions using standardized coefficients. Then, we estimate the
direct effect of disclosure as the coefficient of disclosure on the cost of capital (2 in Eq. 4). The
indirect effect is the product of the coefficient on disclosure in the ownership model with the
coefficient of ownership in the cost of capital model (11 in Eq. 3 and 4). The total effect ((11)
+ 2) is then the sum of the direct and indirect effect.
Focusing on systematic realized returns in the top of the panel, the direct effect of
disclosure equals -0.48 in the two-way sorts and -0.26 in the one-way sorts. Since the annual
standard deviation of systematic realized returns is 2.02% (2.72%) for the one-way (two-way)
sorts, the one-way (two-way) estimate suggests a 97 (71) basis point decrease in the cost of
capital for a one standard increase in disclosure quality. The indirect effect, on the other hand, is
a positive for both sorts, again consistent with a substitute relation between disclosure and
ownership. Specifically, an increase in disclosure is associated with a reduction in ownership.
However, because reduced ownership increases the cost of capital, the indirect effect is that
higher disclosure increases the cost of capital via ownership. For systematic realized returns in
the top of the panel, the total effect of disclosure equals -0.38 in the two-way sorts and -0.19 in
the one-way sorts. Thus, the one-way (two-way) estimate suggests a 78 (52) basis point net
decrease in the cost of capital for a one standard increase in disclosure quality (after accounting
for the indirect effect).
For systematic implied cost of capital in the bottom of the panel, the total effects are
slightly smaller. The total effect of disclosure equals -0.56 in the two-way sorts and -0.36 in the
one-way sorts. Since the annual standard deviation of systematic implied cost of capital is 1.02%

30

(1.24%) for the one-way (two-way) sorts, the one-way (two-way) estimate suggests a 58 (44)
basis point net decrease in the cost of capital for a one standard increase in disclosure quality
(after accounting for the indirect effect).
5.

Conclusion
In this study, we examine (i) whether greater inside ownership is associated with a lower

cost of capital and (ii) whether inside ownership is important in mediating the relation between
disclosure quality and the cost of capital. Prior theory suggests that ownership can directly affect
the systematic cost of capital due to lower managerial misappropriation and to managerial risk
aversion (e.g., La Porta et al. (2002); Himmelberg et al. (2004)). In addition, Lambert et al.
(2007) suggest that disclosure can have direct and indirect effects on the cost of capital, with the
indirect effect flowing through governance mechanisms such as inside ownership. Our study
tests these predictions.
We test these hypotheses on a sample of 51,503 firm-year observations from 36 countries
between 1990 and 2005. We first confirm prior findings that ownership is negatively related to
disclosure quality, and that disclosure quality is negatively related to the cost of capital. We then
examine the role of ownership, and find that it is significantly negatively related to the cost of
capital. Using path analysis, we connect these results to compute the direct and indirect effects of
disclosure on the cost of capital. We find that, while the direct effect of disclosure is negative,
the indirect effect is positive. Greater disclosure quality reduces ownership and lower ownership
increases the cost of capital. This is consistent with a substitute relation between disclosure and
ownership. Our final set of tests focus on the determinants of the systematic component of the
cost of capital. We find consistent evidence of a negative relation between ownership and the
systematic cost of capital.

31

Our results make several contributions to the literature. First, we predict and show a
negative relation between ownership and cost of capital. Prior literature documents a positive
relation between ownership and firm value. We extend this literature by suggesting that this
finding is at least partially driven by decreases in the cost of capital. Second, we provide
evidence of the direct and indirect effects of disclosure on the cost of capital. Specifically, we
show that the direct effect is negative whereas the indirect effect is positive, which attenuates the
total negative relation between disclosure quality and the cost of capital. While prior theory
suggests this complex relation between disclosure and the cost of capital, empirical evidence of
these effects are new.

32

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35

EXHIBIT 1
Structural Model of Disclosure Regulation, Inside Ownership, and Cost of Capital

The graph depicts a structural model between disclosure quality or other governance factors and systematic cost of capital, either directly or indirectly via
inside ownership. Rectangles represent exogenous and endogenous variables, arrows stand for stipulated causal relations, and rounded boxes indicate the
underlying theoretical argument. We also indicate the direction of the causal relations.

36

TABLE 1
Sample Composition and Descriptive Statistics by Country
Country
Argentina
Australia
Austria
Belgium
Brazil
Canada
Chile
Denmark
Finland
France
Germany
Greece
Hong Kong
India
Indonesia
Ireland
Israel
Italy
Japan
Korea (South)
Malaysia
The Netherlands
New Zealand
Norway
Philippines
Portugal
Singapore
South Africa
Spain
Sri Lanka
Sweden
Switzerland
Taiwan
Thailand
United Kingdom
United States
Total (Mean)

Unique
Firms
11
368
36
77
59
295
33
102
92
437
314
46
242
94
75
45
14
158
1,005
173
260
180
72
102
34
45
194
183
118
10
169
140
131
108
1,050
4,523
10,995

FirmYears
35
1,601
128
400
122
836
121
455
400
2,274
1,367
82
793
235
209
218
30
519
3,753
448
1,108
962
313
390
111
131
781
770
603
29
702
765
234
276
4,864
25,438
51,503

Implied Cost
of Capital
12.29
10.88
11.51
11.27
16.23
10.82
13.05
11.47
13.05
10.92
10.79
12.61
13.68
12.56
15.92
12.57
10.82
10.90
8.15
14.43
10.70
12.75
11.31
12.88
12.38
11.56
10.99
16.06
11.28
17.29
11.98
11.34
12.11
14.84
11.31
10.60
10.93

Realized
Returns
-8.45
12.77
16.95
10.97
18.97
13.92
10.25
11.18
19.28
13.23
8.87
22.39
10.42
26.19
3.44
19.97
22.61
12.22
12.93
15.56
3.93
12.16
11.73
13.99
18.59
7.26
7.97
13.49
19.16
-11.49
16.05
14.75
8.77
13.09
9.41
15.18
13.53

Inside
Ownership
57.84
32.87
53.39
51.23
47.82
27.33
60.80
33.27
34.63
51.24
49.11
52.51
54.33
50.77
63.29
25.54
47.57
46.78
40.55
32.45
50.26
41.15
54.07
38.99
72.04
49.65
53.31
50.26
44.05
21.95
34.35
39.25
26.61
51.42
19.55
20.79
30.08

Disclosure
Regulation
0.50
0.75
0.25
0.42
0.25
0.92
0.58
0.58
0.50
0.75
0.42
0.33
0.92
0.92
0.50
0.67
0.67
0.67
0.75
0.75
0.92
0.50
0.67
0.58
0.83
0.42
1.00
0.83
0.50
0.75
0.58
0.67
0.75
0.92
0.83
1.00
0.86

Legal
Quality
0.53
1.00
1.00
1.00
0.63
1.00
0.70
1.00
1.00
0.90
0.92
0.62
0.82
0.42
0.40
0.78
0.48
0.83
0.90
0.53
0.68
1.00
1.00
1.00
0.27
0.87
0.86
0.44
0.78
0.19
1.00
1.00
0.85
0.62
0.86
1.00
0.93

Log(GDP)

Inflation

12.52
12.84
12.12
12.30
13.38
13.40
11.19
11.91
11.66
14.03
14.40
11.79
11.99
13.11
12.03
11.39
11.72
13.88
15.35
13.12
11.32
12.75
10.80
11.96
11.27
11.57
11.26
11.78
13.19
9.54
12.35
12.40
13.11
11.80
14.11
15.98
14.65

0.50
2.52
1.82
1.87
7.11
2.06
4.42
2.11
1.19
1.70
1.94
3.87
3.08
4.74
8.52
3.23
2.11
2.72
-0.18
3.51
2.67
2.33
1.94
2.04
5.45
3.04
1.25
6.19
3.42
7.06
1.22
0.90
1.15
2.54
2.74
2.65
2.40
(continued)

37

TABLE 1 Continued
The sample comprises 51,503 firm-year observations from 36 countries between 1990 and 2005 with sufficient financial data from Worldscope, analyst
forecast data from I/B/E/S, and stock price data from Datastream to compute the dependent and independent variables in our analyses. For simplicity, we refer
to Hong Kong as a country, although it has the status of a Special Administrative Region (SAR) of the Peoples Republic of China. The sample excludes
countries with less than ten individual firm observations or with inflation rates above 25%, and firms with market value below 5 US$ million. The table reports
the number of unique firms, the number of firm-year observations, and the means of the primary test variables and control variables by country. The Implied
Cost of Capital is the average cost of capital estimate implied by the mean I/B/E/S analyst consensus forecasts and stock prices using the Claus and Thomas
(2001) model, the Gebhardt, Lee, and Swaminathan (2001) model, the Ohlson and Juettner-Nauroth (2005) model, and the Easton (2004) model. See Hail and
Leuz (2006) for details on the estimation procedure. Realized Returns are buy-and-hold returns computed over one year, using price information adjusted for
dividends and stock splits, and translated into US$. We measure implied costs of capital and realized returns as of month +10 after the fiscal-year end, and
truncate both variables at the first and 99th percentile. Inside Ownership equals the number of closely held shares by corporate insiders (Field 05475) divided
by the number of common shares outstanding (Field 05301) as defined in Worldscope. We measure the level of Disclosure Regulation by the index of
disclosure requirements in securities offerings from La Porta, Lopez-de-Silanes, and Shleifer (2006). Legal Quality represents the general quality of the legal
environment and is measured as the rule of law index (divided by 10) from La Porta et al. (1997). GDP is countries annual gross domestic product (in constant
US$ billion) as reported by the World Bank. We transform GDP using the natural log. Inflation is the yearly median of country-specific, one-year-ahead
realized monthly percentage changes in local consumer price indices as reported in Datastream.

38

TABLE 2
Descriptive Statistics for Dependent and Independent Variables
Panel A: Distributional Statistics
Variables (N = 51,503)

Mean

Test Variables (%):

Implied Cost of Capital
10.93
Realized Returns
13.53
Inside Ownership
30.08
Control Variables for Ownership Model:
Sales (US$ million)
2,577.5
Sales/PPE
8.254
R&D/Sales
0.018
R&D Indicator
0.653
Return Variability
0.104
Multiple Shares
0.126
Payout Ratio
0.350
Analyst Following
9.7
GDP (US$ billion)
5,004.3
Control Variables for Cost of Capital Models:
Inflation
2.404
Market Value (US$ million)
3,249.1
Book-to-Market
0.580
Earnings Variability
0.033
Forecast Bias
0.006
Multiple Shares
0.126
Payout Ratio
0.350
Analyst Following
9.7

Std. Dev.
3.53
43.83
23.86

P1

P25

5.19
-70.93
0.03

8.54
-13.33
9.66

Median
10.29
9.33
26.05

P75

P99

12.62
33.79
48.32

22.65
164.39
87.11

11,901.8
14.425
0.045
0.476
0.057
0.332
0.380
7.8
3,994.4

1.4
0.177
0.000

152.9
2.086
0.000

487.4
4.227
0.000

1,696.4
8.070
0.011

32,310.3
79.361
0.213

0.029

0.065

0.090

0.127

0.309

0.000
1
56.3

0.000
4
688.9

0.284
8
4,885.1

0.497
14
8,647.6

1.778
34
10,623.9

1.539
12,561.9
0.396
0.052
0.033
0.332
0.380
7.8

-0.885
25.4
0.072
0.001
-0.048

1.546
212.9
0.315
0.009
-0.003

2.436
605.6
0.495
0.018
0.000

3.034
1,990.1
0.734
0.036
0.006

8.734
46,840.9
2.020
0.275
0.158

0.000
1

0.000
4

0.284
8

0.497
14

1.778
34
(continued)

39

TABLE 2 Continued
Panel B: Pearson/Spearman Correlation Coefficients for Ownership Model
Variables
(N = 51,503)
Inside Ownership
Log(Sales)
Sales/PPE
R&D/Sales
R&D Indicator
Return Variability
Multiple Shares
Payout Ratio
Log(Analyst
Following)
Log(GDP)

Inside
Ownership
1
-0.342
(0.00)
0.050
(0.00)
-0.075
(0.00)
0.105
(0.00)
0.115
(0.00)
0.116
(0.00)
-0.100
(0.00)
-0.232
(0.00)
-0.275
(0.00)

Log(Sales)
-0.304
(0.00)
1
-0.006
(0.17)
-0.065
(0.00)
-0.117
(0.00)
-0.154
(0.00)
0.013
(0.00)
0.097
(0.00)
0.417
(0.00)
0.207
(0.00)

Sales/PPE
0.013
(0.00)
-0.023
(0.00)
1
-0.024
(0.00)
0.103
(0.00)
0.107
(0.00)
-0.004
(0.32)
-0.100
(0.00)
-0.088
(0.00)
0.061
(0.00)

R&D/Sales
-0.125
(0.00)
0.063
(0.00)
0.033
(0.00)
1
-0.549
(0.00)
0.256
(0.00)
-0.047
(0.00)
-0.169
(0.00)
0.028
(0.00)
0.171
(0.00)

R&D
Indicator
0.113
(0.00)
-0.108
(0.00)
-0.002
(0.63)
-0.971
(0.00)
1
-0.122
(0.00)
0.030
(0.00)
0.053
(0.00)
-0.046
(0.00)
-0.124
(0.00)

Return
Variability
0.102
(0.00)
-0.167
(0.00)
0.178
(0.00)
0.154
(0.00)
-0.116
(0.00)
1
-0.036
(0.00)
-0.264
(0.00)
-0.123
(0.00)
0.108
(0.00)

Multiple
Shares

Payout
Ratio

0.127
(0.00)
0.034
(0.00)
-0.035
(0.00)
-0.035
(0.00)
0.030
(0.00)
-0.029
(0.00)
1

-0.032
(0.00)
0.153
(0.00)
-0.222
(0.00)
-0.133
(0.00)
0.080
(0.00)
-0.397
(0.00)
0.015
(0.00)
1

0.002
(0.68)
0.064
(0.00)
-0.177
(0.00)

0.080
(0.00)
-0.225
(0.00)

Log(Analyst
Following)
-0.189
(0.00)
0.477
(0.00)
-0.141
(0.00)
0.042
(0.00)
-0.044
(0.00)
-0.132
(0.00)
0.065
(0.00)
0.149
(0.00)
1
-0.120
(0.00)

Log(GDP)
-0.356
(0.00)
0.159
(0.00)
0.170
(0.00)
0.126
(0.00)
-0.084
(0.00)
0.134
(0.00)
-0.142
(0.00)
-0.371
(0.00)
-0.144
(0.00)
1
(continued)

40

TABLE 2 Continued
Panel C: Pearson/Spearman Correlation Coefficients for Cost of Capital Models
Variables
(N = 51,503)
Implied Cost of
Capital
Realized Returns
Inside Ownership
Inflation
Log(Market
Value)
Book-to-Market
Earnings
Variability
Forecast Bias
Multiple Shares
Payout Ratio
Log(Analyst
Following)

Implied
Cost of
Capital
1
0.051
(0.00)
0.087
(0.00)
0.236
(0.00)
-0.359
(0.00)
0.306
(0.00)
0.083
(0.00)
0.271
(0.00)
0.031
(0.00)
0.010
(0.02)
-0.189
(0.00)

Realized
Returns
0.027
(0.00)
1
-0.003
(0.43)
0.003
(0.43)
-0.031
(0.00)
0.074
(0.00)
0.007
(0.10)
-0.102
(0.00)
-0.004
(0.40)
-0.008
(0.06)
-0.049
(0.00)

Inside
Ownership
0.060
(0.00)
-0.032
(0.00)
1
-0.087
(0.00)
-0.331
(0.00)
0.106
(0.00)
0.027
(0.00)
0.063
(0.00)
0.116
(0.00)
-0.100
(0.00)
-0.232
(0.00)

Inflation
0.190
(0.00)
0.018
(0.00)
-0.159
(0.00)
1
-0.034
(0.00)
-0.063
(0.00)
0.027
(0.00)
-0.006
(0.19)
0.013
(0.00)
-0.012
(0.01)
0.053
(0.00)

Log(Market Value)
-0.365
(0.00)
0.013
(0.00)
-0.266
(0.00)
-0.022
(0.00)
1
-0.323
(0.00)
-0.157
(0.00)
-0.116
(0.00)
0.066
(0.00)
0.103
(0.00)
0.667
(0.00)

BooktoMarket
0.314
(0.00)
0.086
(0.00)
0.094
(0.00)
-0.081
(0.00)
-0.318
(0.00)
1
-0.099
(0.00)
0.103
(0.00)
0.022
(0.00)
0.105
(0.00)
-0.218
(0.00)

Earnings
Variability
0.088
(0.00)
-0.035
(0.00)
0.028
(0.00)
0.041
(0.00)
-0.167
(0.00)
-0.231
(0.00)
1
0.029
(0.00)
-0.032
(0.00)
-0.146
(0.00)
-0.118
(0.00)

Forecast
Bias

Multiple
Shares

Payout
Ratio

0.180
(0.00)
-0.190
(0.00)
0.037
(0.00)
0.002
(0.66)
-0.053
(0.00)
0.027
(0.00)
0.003
(0.47)
1

0.025
(0.00)
-0.002
(0.68)
0.127
(0.00)
-0.043
(0.00)
0.068
(0.00)
0.026
(0.00)
-0.049
(0.00)
-0.006
(0.15)
1

0.015
(0.00)
0.024
(0.00)
-0.032
(0.00)
-0.028
(0.00)
0.157
(0.00)
0.137
(0.00)
-0.283
(0.00)
0.002
(0.73)
0.015
(0.00)
1

-0.003
(0.43)
-0.008
(0.08)
-0.074
(0.00)

0.002
(0.68)
0.064
(0.00)

0.080
(0.00)

Log(Analyst
Following)
-0.177
(0.00)
-0.028
(0.00)
-0.189
(0.00)
0.032
(0.00)
0.683
(0.00)
-0.211
(0.00)
-0.101
(0.00)
-0.022
(0.00)
0.065
(0.00)
0.149
(0.00)
1
(continued)

41

TABLE 2 Continued
The sample comprises 51,503 firm-year observations from 36 countries between 1990 and 2005 with financial data from Worldscope, analyst forecast data
from I/B/E/S, and stock price data from Datastream. In Panel A, we report descriptive statistics for the dependent variables and various independent variables
used in the analyses. In Panel B and Panel C, we report Pearson (below the diagonal) and Spearman (above the diagonal) correlation coefficients for the
variables used in the ownership and cost of capital models, respectively. We use the following three primary test variables: (1) the Implied Costs of Capital are
the means of four estimates for the implied cost of equity capital (Hail and Leuz, 2006). (2) Realized Returns are yearly buy-and-hold returns. (3) Inside
Ownership equals the number of closely held shares by corporate insiders (Field 05475) divided by the number of common shares outstanding (Field 05301) as
defined in Worldscope. The independent variables are: Sales equal gross sales and other operating revenue less discounts, returns and allowances in US$
million. Sales/PPE is sales divided by gross property, plant and equipment. R&D/Sales is the ratio of research and development expense divided by sales. If
research and development expense is missing, we set the R&D Indicator variable equal to one. Return Variability is the annual standard deviation of monthly
stock returns. Multiple Shares indicates which firms have more than one type of common shares or ordinary shares as defined in Worldscope (Field 11501).
This variable is only available for the most recent fiscal year and therefore time-invariant. We measure the Payout Ratio as dividends per share divided by
earnings per share. Analyst Following is the number of analysts issuing one-year-ahead earnings forecasts in I/B/E/S. GDP is countries annual gross domestic
product (in constant US$ billion) as reported by the World Bank. Inflation is the yearly median of country-specific, one-year-ahead realized monthly
percentage changes in local consumer price indices as reported in Datastream. Market Value is stock price times the number of shares outstanding (in US$
million). Book-to-Market is the ratio of the accounting book value to the market value of equity. We measure Earnings Variability as a firms standard
deviation of annual earnings per share over the last five years scaled by total assets per share. We require at least three annual earnings per share observations
to compute this variable. Forecast Bias is the one-year-ahead I/B/E/S analyst forecast error (mean forecast minus actual) scaled by forecast-period stock price.
Accounting data and market values are measured as of the fiscal-year end, implied costs of capital, realized returns, return variability and forecast bias as of
month +10 after the fiscal-year end. We use the natural log of raw variables where indicated. For Inside Ownership we use the logit transformation of the
percentage of inside ownership in the analyses, i.e., ln(x/(1 x)) where x is the raw value. Except for variables with natural lower or upper bounds, we truncate
all variables at the first and 99th percentile.

42

TABLE 3
Determinants of Inside Ownership
Variables
Test Variables:
Disclosure Regulation

(1)

Log(Sales)2
Sales/PPE
R&D/Sales
R&D Indicator
Return Variability
Multiple Shares
Payout Ratio
Log(Analyst Following)
Log(GDP)
Fixed Effects:
Industry
Year
Country
R2
N

(3)

-2.555**
(-2.47)
-1.886**
(-2.10)

Legal Quality
Control Variables:
Log(Sales)

(2)

(4)

(5)

-2.880***
(-2.75)
-2.424**
(-2.34)

-0.682*
(-1.94)
-1.710***
(-4.62)

0.459**
(2.29)
-0.028***
(-2.74)
0.005
(1.60)
-3.517***
(-4.76)
0.221
(1.13)
2.255***
(4.39)
0.505*
(1.88)
-0.520***
(-3.33)
-0.241**
(-2.11)
-0.306***
(-4.37)

0.744***
(4.40)
-0.038***
(-4.72)
0.004
(1.42)
-2.616***
(-4.65)
0.336**
(2.38)
2.417***
(4.07)
0.452
(1.65)
-0.584***
(-4.39)
-0.277***
(-2.74)
-0.067
(-0.55)

0.680**
(2.45)
-0.035***
(-3.24)
0.006***
(7.50)
-2.018***
(-3.52)
0.290***
(3.36)
1.768***
(3.69)
0.635***
(3.23)
-0.514***
(-3.36)
-0.372***
(-8.25)
0.721
(1.12)

0.721***
(3.76)
-0.037***
(-3.83)
0.006**
(2.67)
-2.093**
(-2.51)
0.480**
(2.63)
2.159**
(2.57)
0.470*
(1.80)
-0.581***
(-4.54)
-0.363***
(-3.27)
-0.066
(-0.52)

0.474
(1.60)
-0.023
(-1.64)
0.017
(0.40)
8.376
(1.04)
1.416***
(3.77)
-0.360
(-0.27)
-0.296
(-1.30)
0.399
(0.94)
0.340***
(2.88)
-0.129*
(-1.79)

Yes
Yes
No

Yes
Yes
No

Yes
Yes
Yes

Yes
Yes
No

Yes
Yes
No

24.20%
51,503

27.16%
51,503

37.11%
51,503

27.10%
40,508

59.16%
386

The sample comprises up to 51,503 firm-year observations from 36 countries between 1990 and 2005 (see Table 1).
The table reports various specifications of the ownership model. Models 1 though 4 are based on firm-year
observations. Model 3 includes country fixed effects. In Model 4, in the spirit of an initial public offering model, we
set the independent variables equal to the earliest realization per firm over the sample period, and delete the
corresponding first firm-year observation from the analysis. In Model 5, we aggregate the firm-year observations
into 386 country-year observations by computing medians. For binary indicator variables (e.g., multiple shares) we
compute the country-year means instead. We require at least 10 firm-year observations for a given country and year
to be included in the country-year analysis. We use Inside Ownership, i.e., the number of closely held shares by
corporate insiders divided by the number of common shares outstanding, as the dependent variable. We apply the
following logit transformation to the percentage of inside ownership: ln(x/(1 x)), where x is the raw value. We
measure the level of Disclosure Regulation by the index of disclosure requirements in securities offerings from La
Porta, Lopez-de-Silanes, and Shleifer (2006). Legal Quality represents the general quality of the legal environment
and is measured as the rule of law index from La Porta et al. (1997). For a description of the remaining control
variables see Table 2. We use the natural log of the raw values and square the variables where indicated. We include
an intercept, one-digit SIC industry, year, and country fixed effects in the regressions, but do not report the
coefficients. We report OLS coefficient estimates and (in parentheses) t-statistics based on robust standard errors
that are clustered by country. ***, **, and * indicate statistical significance at the 1%, 5%, and 10% levels (twotailed), respectively.

43

TABLE 4
Regression Analysis of Cost of Capital on Inside Ownership and Disclosure Regulation
Panel A: Implied Cost of Capital as Dependent Variable
Variables
Test Variables:
Inside Ownership

(1)
OLS
-0.027
(-0.57)

(2)
OLS
-0.054***
(-2.78)

(3)
OLS

(5)
2SLS

(6)
2SLS

(7)
2SLS

-0.640***
(-3.37)

-0.406*
(-1.75)

-0.328***
(-3.08)

-0.279
(-1.43)

-1.188*
(-1.82)
-2.520*
(-1.86)

-0.615**
(-2.62)
-0.071
(-1.55)
-2.765**
(-2.36)
-3.786**
(-2.31)

-2.619***
(-2.73)
-4.342***
(-2.84)

-2.006**
(-2.17)
-3.563**
(-2.64)

-2.018**
(-2.55)
-3.356**
(-2.26)

-2.251***
(-2.77)
-2.246
(-1.46)

0.517***
(3.67)
-0.584***
(-4.37)
1.831***
(6.14)
4.892***
(8.52)
21.572***
(10.17)
0.376
(1.12)
0.024
(0.24)
0.029
(0.24)

0.528***
(3.54)
-0.761***
(-7.89)
1.683***
(6.51)
4.945***
(8.28)
21.525***
(10.17)
0.660**
(2.37)
-0.310*
(-1.76)
-0.072
(-0.43)

0.420***
(3.23)
-0.792***
(-7.41)
1.666***
(7.09)
4.047***
(4.92)
21.855***
(10.01)
0.706***
(3.06)
-0.350*
(-1.75)
-0.049
(-0.30)

0.462***
(4.19)
-0.703***
(-4.69)
1.737***
(5.90)
4.409***
(7.97)
21.734***
(10.25)
0.565
(1.65)
-0.190
(-0.90)
-0.016
(-0.12)

0.532***
(3.90)
-0.620***
(-5.25)
1.916***
(6.77)
4.203***
(5.54)
20.996***
(8.77)
0.461*
(1.82)
-0.098
(-0.80)
-0.012
(-0.10)

0.316***
(3.22)
-0.500
(-1.57)
2.475***
(2.83)
82.694***
(4.59)
73.953***
(5.69)
0.917
(1.28)
0.344
(0.30)
-0.411
(-1.24)

-0.093**
(-2.43)

Inside OwnershipPred
Inside OwnershipResid
Disclosure Regulation
Legal Quality
Control Variables:
Inflation
Log(Market Value)
Book-to-Market
Earnings Variability
Forecast Bias
Multiple Shares
Payout Ratio
Log(Analyst Following)
Fixed Effects:
Industry
Year
Country
R2
N

0.592***
(5.08)
-0.602***
(-5.05)
1.984***
(6.16)
4.833***
(8.82)
22.063***
(10.16)
0.426
(1.26)
0.242
(1.69)
0.142
(1.45)

0.166***
(3.00)
-0.472***
(-7.56)
1.968***
(8.97)
3.698***
(6.30)
21.822***
(10.53)
-0.134
(-1.35)
-0.003
(-0.02)
-0.077
(-1.18)

(4)
OLS

Yes
Yes
No

Yes
Yes
Yes

Yes
Yes
No

Yes
Yes
No

Yes
Yes
No

Yes
Yes
No

Yes
Yes
No

31.23%
51,503

37.46%
51,503

32.28%
51,503

32.58%
51,503

24.52%
51,503

29.74%
51,503

30.81%
40,508

(8)
OLS

Yes
Yes
No
64.81%
386
(continued)

44

TABLE 4 Continued
Panel B: Realized Returns as Dependent Variable
Variables
Test Variables:
Inside Ownership

(1)
OLS
-0.362
(-1.59)

(2)
OLS
0.060
(0.70)

(3)
OLS

(5)
2SLS

(6)
2SLS

(7)
2SLS

-6.665***
(-2.96)

-2.074*
(-1.89)

-5.082***
(-3.43)

-2.772*
(-1.72)

2.829
(0.94)
11.585**
(2.04)

-6.511***
(-5.05)
0.122
(0.50)
-16.197***
(-3.61)
-4.484
(-0.78)

-16.215**
(-2.24)
-4.664
(-0.45)

-2.821
(-0.68)
6.764
(1.02)

-16.087***
(-3.07)
-4.667
(-0.48)

-7.781*
(-1.85)
2.727
(0.40)

-0.439*
(-1.89)
6.801***
(8.31)
0.281
(0.24)
-1.794***
(-4.62)
-0.290
(-0.59)

-2.612***
(-5.67)
4.933***
(6.20)
3.795***
(3.58)
-5.886***
(-5.67)
-1.503**
(-2.18)

-2.840***
(-4.13)
5.385***
(4.01)
3.864**
(2.31)
-6.146***
(-3.48)
-1.303
(-0.98)

-1.151***
(-4.21)
6.381***
(8.80)
1.344
(1.59)
-3.085***
(-4.61)
-0.591
(-0.90)

-2.176***
(-4.43)
6.006***
(5.69)
2.648**
(2.71)
-6.311***
(-8.76)
-1.233
(-1.18)

-2.437
(-1.43)
12.029*
(1.77)
-1.504
(-0.41)
-2.015
(-0.34)
1.669
(0.92)

-0.137
(-0.67)

Inside OwnershipPred
Inside OwnershipResid
Disclosure Regulation
Legal Quality
Control Variables:
Log(Market Value)
Book-to-Market
Multiple Shares
Payout Ratio
Log(Analyst Following)
Fixed Effects:
Industry
Year
Country
R2
N

-0.358
(-1.34)
6.312***
(8.47)
0.202
(0.15)
-2.502***
(-5.27)
-0.678
(-1.32)

-0.659**
(-2.45)
7.309***
(8.22)
-0.058
(-0.04)
-0.737
(-1.37)
0.365
(0.58)

(4)
OLS

(8)
OLS

Yes
Yes
No

Yes
Yes
Yes

Yes
Yes
No

Yes
Yes
No

Yes
Yes
No

Yes
Yes
No

Yes
Yes
No

Yes
Yes
No

6.23%
51,503

6.84%
51,503

6.35%
51,503

6.65%
51,503

3.71%
51,503

5.71%
51,503

1.69%
40,508

46.85%
386

The sample comprises up to 51,503 firm-year observations from 36 countries between 1990 and 2005 (see Table 1). The table reports various specifications of
the cost of capital model using the Implied Cost of Capital (Panel A) or the Realized Returns (Panel B) as the dependent variable. Models 1 though 7 are based
on firm-year observations. Model 2 includes country fixed effects. In Model 4, we split the actual values of Inside Ownership into the predicted values and the
residual values from the ownership model as described in Model 2 of Table 3. We use the same specification of the ownership model in the first stage of a twostage-least-squares estimation (2SLS) and report the second stage results in Model 5. Models 6 and 7 also reflect 2SLS estimation, but we replace the countrylevel variables of the first stage by country fixed effects (Model 6), or use the initial public offering model from Table 3 in the first stage (Model 7). In Model
8, we aggregate the firm-year observations into 386 country-year observations by computing medians. For binary indicator variables we compute the countryyear means instead. We require at least 10 firm-year observations for a given country and year to be included. For a description of the dependent and control
variables see Table 2. We use the natural log of the raw values where indicated. We include an intercept, one-digit SIC industry, year, and country fixed effects
in the regressions, but do not report the coefficients. We report OLS coefficient estimates and (in parentheses) t-statistics based on robust standard errors that
are clustered by country. ***, **, and * indicate statistical significance at the 1%, 5%, and 10% levels (two-tailed), respectively.

45

TABLE 5
Path Analysis of the Effect of Disclosure Regulation on Cost of Capital via Inside Ownership
Panel A: Implied Cost of Capital as Dependent Variable

Variables
Direct Effect:
(i) Disclosure Regulation
Indirect Effect:
(ii) Disclosure Regulation
(iii) Inside Ownership
(iv) Total Indirect [(ii)*(iii)]
Total Effect [(i) + (iv)]

Firm-Year Analysis (N = 51,503)

(1) OLS
(2) 2SLS
Std. Coefficients
Percent
Std. Coefficients
Percent
-0.057*
(-1.82)
-0.235**
(-2.47)
-0.049**
(-2.43)
0.012
-0.045

127%

-27%
100%

-0.126***
(-2.73)
-0.201***
(-3.08)
-0.334***
(-3.37)
0.067
-0.059

214%

Country-Year Analysis (N = 386)

(3) OLS
Std. Coefficients
Percent
-0.185***
(-2.77)

112%

-114%

-0.237*
(-1.94)
-0.085
(-1.43)
0.020

-12%

100%

-0.165

100%

Panel B: Realized Returns as Dependent Variable

Variables
Direct Effect:
(i) Disclosure Regulation
Indirect Effect:
(ii) Disclosure Regulation
(iii) Inside Ownership
(iv) Total Indirect [(ii)*(iii)]
Total Effect [(i) + (iv)]

Firm-Year Analysis (N = 51,503)

(1) OLS
(2) 2SLS
Std. Coefficients
Percent
Std. Coefficients
Percent
0.010
(0.94)

91%

-0.235**
(-2.47)
-0.005
(-0.67)
0.001

9%

0.011

100%

-0.055**
(-2.24)
-0.231**
(-2.47)
-0.244***
(-2.96)
0.056
0.001

-5,500%

Country-Year Analysis (N = 386)

(3) OLS
Std. Coefficients
Percent
-0.076*
(-1.85)

131%

5,600%

-0.237*
(-1.94)
-0.078*
(-1.72)
0.018

-31%

100%

-0.058

100%

The sample comprises up to 51,503 firm-year observations from 36 countries between 1990 and 2005 (see Table 1). The table reports the direct and indirect
effects of Disclosure Regulation on the Implied Cost of Capital (Panel A) and Realized Returns (Panel B) via Inside Ownership using path analysis and the
structural model described in Exhibit 1. Models 1 and 2 are based on firm-year observations with Model 2 using 2SLS estimation. Model 3 uses aggregate
country-year observations. The direct effect is the standardized coefficient estimate on Disclosure Regulation from the cost of capital model (Table 4, Model
3). The indirect effect equals the standardized coefficient estimate on Disclosure Regulation from the ownership model (Table 3, Model 2) multiplied by the
standardized coefficient estimate on Inside Ownership from the cost of capital model (Table 4, Model 3). The total effect of disclosure regulation is the sum of
the direct and indirect effects. We report standardized OLS coefficient estimates and (in parentheses) t-statistics based on robust standard errors that are
clustered by country. The table reports only the primary variables of interest, but the full set of controls and fixed-effects is included in the regressions. ***, **,
and * indicate statistical significance at the 1%, 5%, and 10% levels (two-tailed), respectively.

46

TABLE 6
Analysis of Inside Ownership, Disclosure Regulation and Systematic Risk
Panel A: Systematic Realized Returns Based on Fama-French Two-Factor Model and Portfolio-Sorts

Variables
Test Variables:
Inside OwnershipPred
Disclosure Regulation
Legal Quality

Two-Way Sorting by
Disclosure Regulation and
Predicted Ownership
(1)
(2)
-0.07***
(3.58)
-0.39***
(4.95)
-0.63***
(3.28)

Control Variables:
Multiple Shares

-0.07**
(2.19)
-0.29
(1.42)
-0.38**
(2.39)

0.04
(0.45)
-0.26
(1.35)
0.02
(0.31)

Payout Ratio
Log(Analyst Following)
R2
N

-0.10**
(2.38)
-0.52***
(3.18)
-0.70***
(3.17)

One-Way Sorting by
Predicted Ownership
Within Country
(3)
(4)

29.30%
84

30.39%
84

-0.10
(1.32)
-0.36
(1.31)
-0.42*
(2.00)
0.04
(0.45)
-0.26
(1.35)
0.02
(0.31)

9.68%
171

11.93%
171

Panel B: Systematic Implied Cost of Capital Based on Fama-French Two-Factor Model and Portfolio-Sorts

Variables
Test Variables:
Inside OwnershipPred
Disclosure Regulation
Legal Quality

Two-Way Sorting by
Disclosure Regulation and
Predicted Ownership
(1)
(2)
-0.04***
(4.61)
-0.27***
(8.11)
-0.26***
(3.07)

Control Variables:
Inflation

-0.03**
(2.43)
-0.22*
(2.01)
-0.20**
(2.36)

-1.16
(1.11)
-1.08
(1.28)
-3.02**
(2.04)
0.10**
(2.50)
-0.16***
(3.26)
-0.05**
(2.35)

Earnings Variability
Forecast Bias
Multiple Shares
Payout Ratio
Log(Analyst Following)
R2
N

-0.08***
(4.68)
-0.39***
(5.70)
-0.53***
(4.07)

One-Way Sorting by
Predicted Ownership
Within Country
(3)
(4)

47.99%
84

58.01%
84

-0.07*
(1.98)
-0.28**
(2.17)
-0.16
(1.25)
1.34
(1.19)
0.80
(1.08)
0.25
(0.23)
0.05
(1.11)
-0.14
(1.49)
0.01
(0.22)

16.25%
171

25.20%
171
(continued)

47

TABLE 6 Continued
Panel C: Path Analysis of the Effect of Disclosure Regulation on Systematic Cost of Capital

Variables

Two-Way Sorting by
Disclosure Regulation and
Predicted Ownership
(1)
Std. Coeff.
Percent

Systematic Realized Returns as Dependent Variable

Direct Effect:
(i) Disclosure Regulation
-0.48***
(4.95)
Indirect Effect:
(ii) Disclosure Regulation
(iii) Inside Ownership
(iv) Total Indirect [(ii)*(iii)]
Total Effect [(i) + (iv)]

-0.24**
(-2.47)
-0.40***
(3.58)
0.096
-0.384

Systematic Implied Cost of Capital as Dependent Variable

Direct Effect:
(i) Disclosure Regulation
-0.67***
(8.11)
Indirect Effect:
(ii) Disclosure Regulation
(iii) Inside Ownership
(iv) Total Indirect [(ii)*(iii)]
Total Effect [(i) + (iv)]

-0.24**
(-2.47)
-0.44***
(4.61)
0.106
-0.564

125%

One-Way Sorting by
Predicted Ownership
Within Country
(2)
Std. Coeff.
Percent

-0.26
(1.42)

137%

-25%

-0.24**
(-2.47)
-0.29**
(2.19)
0.070

-37%

100%

-0.190

100%

119%

-0.44*
(2.01)

122%

-19%

-0.24**
(-2.47)
-0.33**
(2.43)
0.079

100%

-0.361

-22%
100%
(continued)

48

TABLE 6 Continued
The base sample comprises 51,503 firm-year observations from 36 countries between 1990 and 2005 (see Table 1).
The table reports results from regression analyses of the systematic component of cost of capital on Inside
Ownership, Disclosure Regulation and additional control variables. In Panel A (for Realized Returns) and Panel B
(for Implied Costs of Capital), we sort firms into portfolios using two approaches. For the two-way sorting, we start
with forming 84 portfolios by intersecting ten ranks of Disclosure Regulation with ten ranks of predicted Inside
Ownership based on Model 2 in Table 3. For the one-way sorting, we form 171 portfolios by ranking all firm-year
observations in a given country into five groups based on predicted Inside Ownership. We then match twelve
months of stock returns to each firm-year starting in October of each year t+1.We require a minimum of 60 monthly
return observations per portfolio. For each portfolio we then estimate the following time-series regression: (RP,t
RF,t) = ap + b1,p (RM,t RF,t) + b2,p HMLt + p,t, where RP is the equal-weighted buy-and-hold return of the portfolio, RF
is the return on a one-month U.S. Treasury Bill, RM is a value-weighted return on a world market index from
Datastream, and HML is the Fama and French (1998) value-weighted global book-to-market factor. Next, for
Realized Returns, we calculate the systematic risk of the portfolio by multiplying the fitted coefficients with the
average values of (RM RF) and HML over the estimation period. For the Implied Costs of Capital, we calculate the
systematic risk by multiplying the same fitted coefficients with the value-weighted average implied cost of capital
for our sample (as a proxy for the market risk factor), and with the difference in value-weighted average implied
costs of capital between the sample firms in the three highest and the three lowest book-to-market deciles (as a
proxy for the book-to-market factor). In Panel C, we report the direct and indirect effects of Disclosure Regulation
on systematic cost of capital via Inside Ownership using path analysis and the structural model described in Exhibit
1. The direct effect is the standardized coefficient estimate on Disclosure Regulation from the Fama-French twofactor model with portfolio sorts from Panels A and B (Models 1 and 3). The indirect effect equals the standardized
coefficient estimate on Disclosure Regulation from the ownership model in the firm-year analysis (Table 3, Model
2) multiplied by the standardized coefficient estimate on Inside Ownership from the Fama-French two-factor model
with portfolio sorts. The total effect of disclosure regulation is the sum of the direct and indirect effects. We report
(standardized) OLS coefficient estimates and (in parentheses) t-statistics based on robust standard errors that are
clustered by country. Panel C reports only the primary variables of interest, but the full set of controls and fixedeffects is included in the regressions. ***, **, and * indicate statistical significance at the 1%, 5%, and 10% levels
(two-tailed), respectively.

49