Managing the Information Cost of

Financing
Paul Strebel
The information cost of financing shonld be a concern
of financial managers and top corporate executives. Two
types of information costs are discnssed. The first is
"scarce information premium" which financiers require
as compensation for the risk associated with the unknown
and the second is "financial expectations gap'' which
exists between corporate management and the players in
the financial markets. This article suggests steps that
should be taken to reduce these costs.

DIFFERENCES in the information

and expectations of investors, both
intemational and domestic, can have
a significant impact on a company's cost of capital. The difficulty
of communicating all the relevant information to the financial markets
makes the information possessed by
management and potential financiers
far from identical. Whereas the information which is easiest to communicate tends to be in numerical or
financial form, the most useful information is frequently qualitative or

intangible.
Competitive considerations, moreover, often preclude disclosure of the most sensitive and,
therefore, most relevant information.
As a result, there is plenty of scope
for either lack of information or
differences in expectations to afEect
the price which financiers are willing
to pay for the firm's future cash fiows.

Parkhoed Holding N.V., a Dutch

company, had a pdcer-earnings ratio
of 18 on the Amsterdam exchange in
1974, but was virtually unknown in
the intemational financial community.
An intemational public capital issue
was ruled out; the company reached
agreement with a group of prime
quality banks for a $30 million multicurrency loan managed by the Banque
Europeene de Credit and Morgan
Guaranty as a first step towards
building its image in the intemational
capital market. This was followed
in 1976 by a greatly oversubscribed
$25 million Eurobond issue managed
by the Amsterdam-Rotterdam bank
N.V. and Morgan Stanley Intemational.2

Documented examples are provided

by experience in the intemational
equity markets. Novo Industrii A/S,
a Danish pharmaceutical/biotech company, was selling at 6 times eamings
in Copenhagen early in 1980, but its
Paul Strebel is Professor of Business Ad- management knew that comparable
minstration at the International Management Institute in Lausanne, Switzerland. companies were selling at 15 to 30
He is a consultant in the area of mergers times eamings in New York.^ With
and acquisitions and his current research a series of "road shows", followed by
interests include the role of finance and new issues in both London and New
By contrast with these examples, in
information in outpacing strategies.
York, Novo first gained the attention the economists' perfectly competitive
The author would like to thank Warren of overseas investors, who then helped financial markets the same informaLaw and Henry ReUing of Harvard Uni- to change the expectations of the tion is available to everyone. Manversity, in addition to colleagues at
Danish market by arbitraging the mul- agers cannot create value for their
IMEDE, for their comments on an earlier
tiple up to 17.
shareholders through financing, bedraft.

SUMMER

1986

39

cause the price offered for the company's cash flows is exactly equal to
their value. In this kind of environment, the choice of financing is irrelevant. The larger the informational
differences between managers and
financiers, however, the greater the
potential impact of financing on the
firm's value.
From the corporate financial officer's point of view, there are two
types of informational cost: The first
is the "scarce information premium"
which financiers require as compensation for the uncertainty generated
by lack of information about a company.^ The second, which may be
either positive or negative, is associated with the "financial expectations
gap" about the company's prospects,
which frequently exists between management and its advisors on the one
hand, and the financial markets on
the other.
Understanding the link between
publicly available information and
financing costs is the first step in the
development of an appropriate action
plan aimed at reducing these information costs. For example, does the
company suffer from a lack of research attention on the part of the
financial community, or from a distorted financial image, or both? In
the event of a lack of attention, what
are the financing implications? Should
more financial, strategic, or product
information perhaps be disclosed in
an attempt to gain attention? In the
event of a distorted financial image,
can (should) financial marketing be
used to close the expectations gap?
(See Chart 1).
The answers to these questions de-

pend in part on the country and

capital market in which the company
is located. During the discussion
below, distinctions will be drawn,
where appropriate, between Europe
and the US. It will be assumed that
the company is sufliciently close to its
target capital structure that the other
factors affecting financing costs, such
as taxes, bankruptcy, flexibility, and
control, are more or less offsetting.
Under these conditions, information
costs will be most likely to shape the
financing decision, and the policy
guidelines for reducing such costs will
be most relevant.
REDUCING THE SCARCE
INFORMATION PREMIUM
The quality of publicly available information depends on the concentration of research attention focused on
the firm. The ferreting out of critical
strategic information by security
analysts and others who regularly
follow the company affects the forecasting ability of investors.* As a
result, the general quality of information available to investors refiects the
number of security analysts making
earnings forecasts and the number
of institutions holding shares.
The demand for and supply of
security research depends in turn on
the value of the information provided
to the investor on the one hand, and
the cost of producing it on the other.'^
Information has more value to investors when it concerns companies
which they can relate to, or which are
changing. By the same token, information on lower profile companies is
often difiicult to interpret, while repeated reports on a static situation

CHART 1
REDUCING THE INFORMATION COST OF FINANCING

Is the problem:
(A)
(B)

Lack of Financier Attention?

Distorted Financial Image?

APPROACH A: Reduce the Scarce Information Premium

(i) Use Retained Earnings
(ii) Rely on old Financial Friends
(iii) Attract Attention
APPROACH B: Close the Expectations Gap
(i) Alter Corporate Strategy and Expectations
(ii) Focus Image with Financial Marketing
(iii) Exploit the Expectations Gap

40

have little value. On the supply side,

the production of investment information is more economical when the
company is willing to disclose what
is happening and when the company
is large enough to support a sufficiently large investor base to cover
the fixed costs of security research.
Companies neglected by analysts,
thus, are often small, static, have
low general visibility, or are unwilling to disclose inside information.
This last characteristic is especially
common in continental Europe, where
the penchant for secrecy is common
even among large listed companies,
not to mention smaller family-held
firms. Although very little systematic
data is available, anecdotal evidence
suggests that the vast majority of
European firms are neglected by
security analysts.
But the phenomenon is not unique
to Europe. Even in the largest of the
US markets, some companies receive
broad and continuous coverage from
security analysts, while others get
virtually no attention at all. In a
study of the 1970s, for example, even
large US companies were sometimes
found to be ignored: at any moment,
between 100 and 150 companies included in the S&P500 Index were
lightly covered.*'
The lack of financial attention has
important consequences for the cost
of financing. Neglected "informationally naked" securities sell at a discount
relative to comparable, researched,
"informationally covered" stocks. The
annual return (dividend plus capital
gain) earned by investors on the relatively neglected S&P500 stocks was
consistently higher in 9 to 10 years
studied, 16% on average, compared
with 9% on the highly researched
securities.
The reason apparently is that the
relative lack of information generates
more uncertainty about future cash
flows. At the low levels of information
surrounding
informationally
naked securities, the perceived risk
faced by investors is greater than the
measured risk.^ A scarce information
premium must be added, therefore, to
the measured historical risk premium
when estimating the cost of financing
for neglected firms.

COLUMBIA JOURNAL OF WORLD BUSINESS

To minimize the cost of financing,

neglected firms must either find a way
of increasing their popularity, or of
avoiding the financing premium
associated with scarce information.
An analysis of the possibilities open
to a neglected company suggests, by a
process of elimination, at least three
different actions which management
can take to avoid, or reduce the
scarce information premium.

(ii) Rely on old financial friends

Informationally naked companies
can avoid much of the financing premium associated with scarce information, hy relying on the financiers who
know them hest. By the same token,
the development of ongoing relationships with hanking and other "private" sources of finance is critical.
For secretive European companies this
approach is the norm, rather than
the exception.

(i) Use retained earnings

Financial relationships which reThe information premium is lower
duce
the information premium take
for retained earnings than for other
forms of financing. Management acts effort to develop. Because the finanas a financial agent on hehalf of the cier has to learn and gradually build
existing shareholders and, hy defini- confidence in his information about
tion, has more inside information than the firm, its operations, products, and
the agents of other financing clien- markets, such relationships cannot be
teles. To the extent that financial developed overnight but have to he
clienteles rely on intermediaries such nurtured over time. Bell Canada
as management, investment hankers, Enterprise, for example, hegan studyportfolio managers, and so on, to act ing and building relationships for inas agents for them, the existing share- ternational syndication a full five years
holder clientele is better informed than before making their issue in June
other potential clients. As a result, 1983."
retained earnings have a relatively low
Clearly, the more informationally
information cost of financing. Ne- naked the firm is in the public capital
glected companies, in particular, there- markets, the more important private
fore should use this form of financing. financial relationships become as a
means of reducing the information
But retained earnings financing is cost of financing. Pakhoed's use of
affected hy the dividend decision. private international hank financing
Dividends should not be altered tem- when it was unknown, prior to making
porarily to reflect short run financing a public Eurobond issue when it was
requirements, because the reduction better known, is a good illustration of
in the scarce information financing this point.
premium may he offset by the additional uncertainty created hy a vary- (iii) Attract attention
ing dividend signal.
Small companies can reduce the
scarce information premium by atMany firms are already aware of tracting attention. More attention rethe lower cost of retained earnings. sults in more information being obLarge European companies have long tained hy security analysts and made
followed the practice of building up available to the financial community,
liquid reserves for use as a future thereby reducing the uncertainty assource of financing, rather than in- sociated with the anticipated return
creasing dividends and later going distribution.
to the capital markets. A recent exWell-placed financial publicity has
ample is provided hy Nestle, which
permitted many small firms to project
used part of its liquid reserve of $7
themselves into the financial spotlight.
billion to help finance the take-over The recent equity issues of small highof Carnation for $3 hillion. A recent technology companies fall into this
statistical analysis of existing financial category. Some companies have used
practice in the US also found that the introduction of new products to
retained earnings were a preferred get a "partial free ride in the media."
form of financing. The results of this Thus Apple Computer uses extravastudy were summarized as follows: ganzas "complete with glaring spot"Don't use debt if the earnings fiow lights and loud music", to introduce
is generous enough to make it un- new products to analysts and the
necessary. " 8
press.i"
SUMMER

1986

What is needed, in addition to

favorable publicity, is an aggressive
investment banker-cum-broker with
access to a network of investors interested in speculative high growth
stocks. A typical example is the case
of two entrepreneurs who, with
nothing other than a pending FCC application for a cordless telephone
license, but with one highly publicized successful venture behind them
and access to aggressive brokers,
raised $2 million of over-the-couiiter
equity.
However, the ability of smaller
firms to move out of the financing
shadows into the spotlight is constrained by their size. From the
analyst's viewpoint, there is often not
enough of a market for the securities
of a small firm to pay for the cost
of security research (except possibly
at the time of a new issue when
underwriting fees come into play).
Moreover, when the main financial
marketing objective of small firms is
merely favorable publicity, it is of
dubious value, because the market
discounts the publicity as such. As a
result, there are limits to what small
firms can do with financial marketing.
For European companies, the traditional aversion to publicity makes it
more difficult to attract attention with
techniques like "product extravaganzas." There is still a definite possibility that these might backfire. On
the other hand, with the increasing
emphasis on raising the level of entrepreneurial activity in Europe, high
profile financial marketing is gradually becoming more common. This development has been accompanied by
a rising interest in venture capital and
by the creation of over-the-counter
markets, not only in London, but also
in Amsterdam, Stockholm, Paris, and
Frankfurt.
Even large US companies, or
whole industries, may suffer from a
lack of financial market visibility
from time to time. This is illustrated by the case of the American
"Do-It-Yourself" industry, or the
savings and loan industry which
spawned 79 new issues all vying for
attention in 1983. Companies catering to the "do-it-yourself" market
were not even recognized as an industry on Wall Street, until Donald
41

average. Thus, financial managers cycle assessment of IBM by the

should try to minimize the cost of market.
financing from their point of view.
The decade of the 1970s, therefore,
But the correct financing choice re- saw a dramatic change in the
quires a reliable view of the financial, markets' view of IBM's future, relaand in particular, the stock market's tive to its current earnings and, hence,
opinion about the company's pros- in its perceived life cycle position.
pects.
This was coincident with a shift in
Fortunately, the stock market itself the leading edge of product market
can be used as a barometer of in- growth from the large computer segvestor opinion about the company's ment of the market, in which IBM
image. The market value of a com- was the leader, towards micropany contains an implicit assessment computers, where the barriers to entry
were much lower, the competition
For most large companies, how- of corporate prospects on the part of more keen and where IBM had yet
ever, the investor relations effort is all traders in the firm's shares. to make an entry. At the time when
aimed more at promoting their image Management can attempt a funda- IBM's strategic reorganization and the
than at establishing awareness of their mental appraisal of whether the "com- plans for the personal computer were
pany is worth its stock price."^^ The
existence.
difference between the managerial and initiated, the relevant information
market values provides an estimate of could not be disclosed for competiCLOSING THE
tive reasons. A financial expectathe expectations gap.
EXPECTATIONS GAP
tions gap between management and
The obvious reaction to an apA related assessment is implicit in the stock market in all likelihood deparently distorted financial image, is the proportion of the firm's value veloped.
some form of financial marketing. which the market associates with
In general, when expectation gaps
But, before deciding on a financial future growth. Breaking the total
open
up, what can financial manamarketing effort, management must value of the corporation into two parts
gers
do
about them?
determine what sort of financial image and then comparing the future growth
the company has: What kind of in- value to the current earnings value (i) Alter corporate strategy and
expectations
formation has been getting through permits an estimate of wliere the
to the financial community? What market sees the company in its life
The financial market's perception
kind of financial clienteles does the cycle.
of the company's life cycle position
company have? Which of them has
and its value provides a provocative
As an example, consider the case external reference point for the critical
the most positive expectations about
the firm's future? For companies of IBM in 1980 before its strategic evaluation of the company's strategy.
listed in more than one market, can reorganization and the initiation of Before proceeding to explore the
the differences between the clienteles the plans for the personal computer. financial implications of a difference
be exploited, as Novo Industries did The total value of IBM in 1980 was of opinion with the market, it bewhen it capitalized on the far more $36 billion based on an average share hooves management to make sure that
bullish sentiment towards biotech price of $61.60. The 1980 net earn- its own house is in order.
stocks in New York, relative to ings after taxes were $3.56 billion.
Using a cost of equity of approxiAn expectations gap may refiect an
Copenhagen?
mately 17%, reffecting a T-Bond error on the part of management
Before considering possible dif- yield of 10% plus a systematic risk rather than the market. Management's
ferences between clienteles, the first premium of 7%, the capitalized expectations may be unrealistic; the
question which must be answered value of the existing earnings stream corporate strategy may be inconsistent
is whether there is a gap between the was $3.56/0.17=$21 billion. The with the environment. If so, manageperception of management and the value attributed to IBM's future ment should change its thinking
financiers as a whole? And if so, what growth was therefore, $36$21= rather than attempt to influence the
should be done about it? For example, $15 billion. Growth value less than market. Corporations with poorly deif the financial markets have a more earnings value is typical of companies fined strategies like the conglomerate
pessimistic view of the company's which the market perceives to be diversifiers of the 1970s, for example,
prospects than management, financ- mature.
ignore the financial market's opining costs look high from manageion at their peril.
In the growth phase, by contrast,
ment's perspective, and vice versa.
An audit of the company's strategic
There is no way of knowing who will the value associated with future potenbe more correct about a particular tial is significantly greater than the position can be carried out by excompany's future, management or the value of current earnings. In 1970, amining the actual quality of growth
market, until after the fact. Owing to the value of IBM's existing business in each of the firm's major subgreater access to inside information, was only $7 billion, while the value of divisions. Is each subdivision creating
however, managers' forecasts usually future growth was $36 billion, which value in the sense that its strategy is
are better than the market's on corresponded to a "high growth" life supported by a long run return on

Davis of Stanley Works and others

created the Do-It-Yourself Research
Institute to promote the industry and
develop research material. Stanley
Works claims that 50 analysts are
'consistently interested' in it, compared with fifteen before the Institute
started. Without ignoring the role of
other factors, it is interesting to note
that the price-earnings ratio of
Stanley Works climbed from an average of 8 in 1980, before the Institute
started, to 14.5 in 1982."

42

COLUMBIA JOURNAL OF WORLD BUSINESS

investment (including the synergistic relevant information is unlikely to

and spin-off benefits of interaction have much effect on the cost of
with other parts of the firm both cur- financing. Analysts prefer straight
rently and in the future) which is shooters: "It serves analysts and ingreater than the shareholders' oppor- vestors over the long run for comtunity cost of the funds tied up in panies to be straightforward, to
the division? WhUe it is important tell us they made a mistake and not
not to underestimate the returns on to try to hype a stock unnecessarily",
current business activities, it is equal- says Merrill Lynch's Vogel.^*
ly important not to write off an apEven for straight shooters, however,
parently low stock market price as
altering
the financial image of a commeaningless, before ensuring that the
pany
is
not
necessarily easy. Unilever,
existing strategy can withstand critical
one of the twenty largest industrial
evaluation.
companies in the world, began its inThe US international banking in- vestor relations effort in 1979 after
dustry, for example, had mid-1983 the $485 million acquisition of
price-earnings ratios which were only National Starch and Chemical Corhalf the market average, well below poration. Several years of presentatheir traditional level. Investors were tions and visits to security analysts
concerned about the security of de- and their meetings made only a
veloping country debt. Based on their small impact on the company's US
public pronouncements, bankers be- shareholdings. What did make a
lieved the problem could be managed. difference, however, was a security
analysts' meeting at Unilever House
The growing politicization of inter- in London, which featured two
national debt rescheduling suggests days of conferences with top manthat the market's estimate of bad debt agement and one day touring a nearwrite-offs may turn out in the end to by R&D facility. IThe analysts were
be more correct than the bankers. most impressed by detailed informaThe financial expectations gap be- tion on Unilever's favorable market
tween the banking industry and the share relative to its competitors, instock market may be more sympto- formation which was not readily
matic, therefore, of a fundamentally available in the US. "Right after the
weak strategic position, rather than a meeting, two analysts who already
case of poor financial marketing on followed Unilever published reports
the part of the banks, or a pricing . . . (and then) two highly respected
error on the part of the market.
household products specialists who
hadn't written up the company be(ii) Focus the company's image with
financial marketing
fore, came out with mildly enthusiCorporate image advertising, de- astic reports recommending purchase".
spite the difficulty of measuring This had a snowball effect and by
whether it has any impact, accounts the end of the year, US investors held
for well over $1 billion in annual US 16% of the stock compared with
media expenditures. One contro- 6% twelve months earlier, while the
versial attempt to test the statistical price increased ten points.^'*
link between corporate advertising and
The possible benefits of disclosing
stock prices did find a positive im- more information than required by
pact: about 4% of the fiuctuation legal and accounting practice depend
in stock prices could be attributed to in the short run on the size of the
corporate advertising expenditures.^^
expectations gap and the estimate of
New product announcements and external funding needs. When both
labor productivity were found to be the gap and the funds needed are
the most effective advertising themes large, so are the information benein terms of stock price impact. By fits associated with disclosure. The
contrast, sales and earnings growth cost of additional disclosure, on the
as themes had little impact. This is other hand, varies with the strucnot surprising, because the financial ture of the industry, tending to be
markets are not easily fooled. A greater in competitive than in monmarketing campaign which does not opolistic environments.
focus on previously undisclosed and
In the case of IBM's personal comSUMMER

1986

puter, the competitive costs of disclosing the approach to the new

product line were very high. Moreover, the financial benefits were
small, because the company did not
require new external financing. Any
short term increase in the stock
price had to be weighed against the
competitive costs of disclosure. Management, therefore, chose to ignore
the financial market's opinion of the
company at that time and allow subsequent events to speak for themselves.
The economics of financial marketing are likely to be especially
favorable when firms engage in fundamental repositioning. The creation
of a strategic focus by divestiture, for
example, may create substantial confusion in the minds of analysts.
Under these circumstances, explanation of the detailed strategy can help
to correct a distorted image. This
is also true for other repositioning
strategies involving the expansion into
new markets, say, or the shift from
older capital intensive to newer high
technology industries.
To communicate the strategy, the
information content of the marketing
campaign needs to be orchestrated
across all the available channels of
communication: annual report, financial press releases, presentations at
security analysts' meetings, as well as
corporate image advertising. When
the objective is to provide input into
the market's determination of the
company's stock price, the campaign
should highlight the business and
financial attributes which affect stock
price: how the strategy is refiected in
the level and risk of the cash fiow, its
anticipated growth rate, and the
amount of investment required to
sustain that growth rate.
An example of what a well conceived financial marketing effort can
achieve is provided by the experience
of Philips. At the beginning of 1983,
only 3% (5 million shares) of the
European side of the company was
held by American investors at a share
price of $7. After a US tour involving 21 presentations in New
York, Boston and Chicago, providing
information of which the company
believes US analysts and investors
were unaware, the share price climbed
43

to $20 in June 1983 and the number

of shares held by Americans to 2 5 %
(47 million) by November 1983.
The role played by other factors in
the share price rise is, of course,
difficult to determine, but the financial marketing campaign did broaden
the US investor base, thereby allowing Philips to benefit from the bullish
US perception of high technology
companies.
(iii) Exploit the Expectations Gap
In pursuing the minimum cost of
financing, management should select
those financial clienteles from whom
it believes the company can get the
best value for the future stream of
cash ffows. Numerous European
companies have been implementing
this principle by capitalizing on the
periodically more bullish sentiment
in the US equity market. Three
examples have been mentioned: Unilever, Philips, and Novo Industrii.
These illustrate the opportunities for
reducing financing costs which come
with multiple stock exchange listings.
Apart from exploiting expectation
gaps between equity markets, the
choice between debt and equity
should refiect management's perspective on the relative valuation of the
firm's financing instruments. Thus,
when management is more optimistic
than the market about the equity
value of the company's
future
growth, it can shift the capital structure towards more debt, provided
the company is not far from its
target capital structure. During the
late 197O's, when IBM's nominal
market value after substantial earnings and asset growth, was less than
it had been a decade earlier, the
company issued debt and repurchased
stock. IBM's management gave as
a reason its belief that the company's
stock was undervalued. Although at
the time the market was unimpressed, subsequent events have
proven management correct.
Conversely, when management is
more pessimistic than the market and
believes the company's equity is
overvalued, it can shift the capital
structure in the other direction towards more equity, Levitz Furniture
effectively followed this approach
when its stock was selling at a market to book ratio of more than 10

44

associated with a larger scarce information premium. As a result, public

financing is less frequent. The main
forms of financing are retained earnings and bank debt. Moreover, to
reduce the scarce information premium, the company's relationship
with its key bankers has to be much
closer. Over time, therefore, bank
There is a caveat, however, for financing plays a more important role
firms with a distorted financial image, than in other more informationally
the benefits of reducing the financial open environments. The amount of
expectations gap must be weighed bank financing needed varies with the
against possible negative effects on growth rate and the retained earnings
other factors infiuencing capital struc- available. But in the long run, whenture. Exploiting the financing gap ever external financing is needed, the
by means of debt financing may lowest information cost alternative is
strain the company's debt capacity bank debt.
and reduce its financial fiexibility.
Conversely, retained earnings and
Assuming that growth and retained
equity financing may result in the earnings differences average out in
forfeiture of tax advantages asso- the long run, it follows that average
ciated with corporate debt.
debt ratios should decrease with the
degree of informational openness in
By the same token, however, the the country's financial markets. The
notion of a target capital structure available data is loosely consistent
must be treated with caution. Only with this hypothesis.
the most visible, highly researched
Although national preferences for
companies, with a stable image, can
afford to ignore the information costs secrecy are difiicult to measure, the
of financing. For other companies, largest countries can be ranked based
the minimum cost capital structure on common perceptions of their fiwill vary with shifts in the expecta- nancial openness. Disclosure requiretions gap, as the company's financial ments, financial accounting and reimage changes over the corporate porting standards, the strength of the
financial media, all have given the
life cycle.
US markets the image of being the
most informationally open. The UK
INTERNATIONAL FINANCING
market is generally regarded as somePATTERNS
what less open. By contrast, the
In concluding, it is worth asking German market, with far less stringent
whether the information cost of fi- disclosure and reporting standards, renancing is consistent, not only with fiects a much greater penchant for
anecdotal evidence, but also with secrecy. The Japanese financial marstatistically observed financing pat- ket is perhaps more open than the
terns. Numerous studies have been German market, based on the scope
made of the determinants of corpo- of the available financial statistics.
rate debt ratios, for example.^^ Al- However, the Japanese have the
though there is disagreement about strongest preference for personal conthe importance of variables like com- tact and long term relationships in
pany size, growth, profitability, risk, their financial dealings. Thus, a bank
and industry, in explaining debt financing in Japan often takes on
ratios, virtually all observers agree on some of the characteristics of equity,
the importance of the country factor. especially with respect to the long
But no satisfactory explanation has term risk assumed by the banks.
yet been given for why the national
location of a company should affect
Taken together, this suggests that
its debt to equity ratio.
the advantages of bank financing,
The information cost of financing associated with a reduction in the
provides a possible explanation. scarce information premium, increase
Countries with weak or non-existent as one moves from the US to the
disclosure requirements and a tradi- UK, Germany, and Japan. Availtion of corporate secrecy, can be able data indicates that average long

during the early 1970s. The real

growth required to justify the market's valuation of the company was
simply not available, given the size
of the furniture market at that time.^*^
The chairman of the company, not
surprisingly, declared his preference
for continued equity financing.

COLUMBIA JOURNAL OF WORLD BUSINESS

run debt ratios also increase in the

same order: for example, the average
debt ratios were estimated as follows
in 1964/5, US: 3 8 % , UK: 4 5 % ,
West Germany: 5 0 % , Japan: 7 2 % ,
and in 1979/80, US: 5 4 % , UK:
5 5 % ; West Germany: 6 0 % , Japan:
78%."
In contrast to the scarce information premium, there is no evidence
of a systematic (consistently positive
or negative) expectations gap between
management and the capital markets,
or between national capital markets.
Since the sign of the expectations

gap changes over time, it does not

consistently favor either debt or
equity. Jn the long run, therefore,
the information cost of financing associated with expectation gaps should
not affect average debt ratios.
But might not the patterns associated with the information cost of
financing merely be manifestations of
segmented capital markets? Will they
not gradually disappear as the markets become more globally integrated?
Greater capital market integration
is likely to reduce the magnitudes of

the expectation gaps across countries,

but not periodic expectation gaps
between management and the markets, which are likely to persist owing
to the economics of information disclosure. More important, the economics of security research is likely
to ensure the continued existence of
a scarce information premium. As a
result, it is unlikely that financial
managers will be able to ignore the
information cost of financing, especially in countries with a strong
cultural
preference
for
financial
secrecy.

NOTES
1. K. Dallum and A. Stonehill, "Internationalizing the Cost
of Capital". The authors attribute part of the increase
in Novo's P/E to the dismantling of institutional barriers to the purchase of its shares.
2. Pakhoed Holding N.V. Case (B), Institut pour I'Etude
des Methodes de Direction de l'Entreprise (IMEDE),
1976.
3. More technically, the unconditional systematic risk is
the expectation of the conditional systematic risk plus the
systematic risk of the conditional expected return. The
scarce information premium is captured by the last
term, which will be positive provided the mean of the
anticipated return distribution varies with the market
environment. (See Note 6).
4. L.D. Brown and M.S. Rozeff, "The Superiority of Analysts Forecasts as Measures of Expectations: Evidence
from Earnings", Journal of Finance, (March 1978).
5. Paul Strebel, "The Information Spotlight", unpublished
manuscript, IMEDE, Lausanne, 1985.
6. Avner Arbel and Paul Strebel, "The Neglected and Small
Firm Effect", Financial Review, (November 1982).
For other studies see Avner Arbel and Paul Strebel,
"Pay Attention to Neglected Firms", Journal of Portfolio
Management, (Winter 1983). Avner Arbel. Steven Carvell and Paul Strebel," Giraffes, Institutions and Neglected
Firms", Financial Analysts' Journal, (May/June 1983).
7. When the mean of the return distribution is unstable the
measured historical risk captures the conditional, rather
than the unconditional systematic risk. (Paul Strebel,
"Analysts Forecasts in the Capital Asset Pricing Model",
Economic Letters, No. 2/3, 1983). At least part of
the estimation risk associated with uncertainty in the

SUMMER 1986

8.

9.
10.
11.
12.
13.
14.
15.
16.
17.

mean of the anticipated return distribution is systematic

to the extent that it varies with the uncertainty in the
environment and, hence, cannot be diversified away.
Michael Spence, "Capital Structure and the Corporation's
Product Market Environment", Harvard Institute of Economic Research, Discussion Paper 898, June 1983.
Apart from the information premium, transaction costs
also favor the use of retained earnings.
Barbara Donnelly, "The Perils of Multimarket Offerings," Institutional Investor, October 1984, p. 287.
Pamela Bayless, "The art of the product launch," Institutional Investor, June 1984, p. 184.
Cathryn Jakobson, "Creating an industry of one's own".
Institutional Investor, 1983, p. 143.
T.R. Piper and W.R Fruhan, "Is Your Stock Worth Its
Price?", Harvard Business Review, May/June, 1981.
For a useful discussion, see Jaye S. Niefeld, Corporate
Advertising", Industrial Marketing, July 1980, pp. 64-74.
Pamela Bayless, "The Art Of The Product Launch",
Institutional Investor, June 1984, p. 186.
Nancy Welles, "How Unilever Got Noticed", Institutional Investor, June 1983, p. 195
W.E. Fruhan, Financial Strategy, (Richard D. Irwin, Inc.
1979).
J.M. Collins and William S. Sekely, "The Relationship
of Headquarter Country and Industry Classification to
Financial Structure", Financial Management, Autumn
1983, pp. 45-51.
R. Aggarwal, "International Differences in Capital Structure Norms" Management International Review, Vol. 21,
1981, pp. 75-88.

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