The relationship between information asymmetry and cost of equity

Dissertation for Master's Degree in Accounting

Abstract

The main purpose of this research is to investigate the relationship between information asymmetry and the cost of equity. The statistical sample of this research included 118 companies admitted to the Tehran Stock Exchange in the period from 1385 to 1391 (a period of 6 years). The present research method is descriptive and correlational. Hypotheses testing is based on multivariable regression and Flimer and Hausman tests and using panel data. The findings of the research indicate that information asymmetry has a direct and significant relationship with the cost of the company's equity, and with the increase in the amount of information asymmetry, the cost of the company's equity also increases.

Key words

Information asymmetry, the difference between the bid and offer price, the cost of equity, the pricing of capital assets.

Introduction

Today, the capital market is one of the basic pillars of growth and development. It is considered the economic of every country. Investment is one of the most important components that determine the fate of every country's economy. The capital market, along with other markets such as the money, labor and commodity markets, is responsible for the optimal allocation of capital. In order to correctly guide decisions in line with the optimal allocation of capital, information plays an essential role in the functioning of the capital market. Because most decisions, including investment decisions, are made in a state of uncertainty (Bolo, 2016).

Capital cost in companies is the cost of providing resources from different groups that are used to carry out the economic activities of the companies. One of these groups is the owners of the company's common shares, and the cost of financial resources provided by this group is considered as the cost of equity (Karami et al., 2013). Several studies have emphasized the importance of capital cost as an important factor in financing and investment decisions. The cost of capital is the weighted average cost of resources financed from debt and equity. Due to the fact that in Iran, the cost of financing through debt is usually determined by order, therefore, in this research, among the components of the cost of capital, only the cost of equity [1] has been considered (Adili, 2008). If the required information is distributed asymmetrically among people, it can cause different results compared to a single issue. Therefore, before the information itself is important to the decision maker, it is the quality of information distribution that must be carefully evaluated. When the information asymmetry[2] regarding a company's stock increases, its intrinsic value will be different from the value that investors in the capital market place on the stock in question. As a result, the real value of the company's shares will be different from the expected value of the shareholders (Diamondo Vrecha [3], 1991).

1-2- Description and statement of the research problem

The cost of capital in general and the cost of equity in particular, is one of the basic topics that is of special importance due to its wide applications in financial literature and has always been the focus of thinkers and experts in this field. The cost of capital has applications such as the criterion for accepting new investment plans, the discount rate for calculating the added value of the market, and the criterion for evaluating capital return rates. In all securities evaluation models, determining the cost of capital and its components, including the cost of equity, is an undeniable necessity, and for this reason, the factors influencing it are always one of the most important challenges in the financial literature (Bolo, 2016). The financial literature states that information plays an important role in determining the cost of equity of companies (Botosan [4], 1997; Butosan and Plumli [5], 2002; Frankis et al., 2005; Lizzo [8], 2000). In addition, firms with more forward-looking disclosure practices have a lower cost of equity. For example, Botusan (1997) stated in relation to manufacturing companies that companies with more information disclosure experience lower cost of equity compared to companies that provide forward-looking information (Peng He et al.For example, Botusan (1997) stated in relation to manufacturing companies that companies that have more information disclosure experience lower cost of equity compared to companies that provide forward-looking information (Peng He et al. [9], 2013).

Identifying the factors affecting the cost of equity in order to calculate the cost of capital of the company is of fundamental importance in the Tehran Stock Exchange market. The cost of capital is used as a key variable in discounting cash flows and, accordingly, calculating the net present value as well as stock valuation. It is obvious that the shareholders attach great importance to the cost of equity and the cost of capital in order to make their predictions and increase their wealth. On the other hand, managers attach great importance to this key variable in order to balance the cost of equity against the cost of debt and ultimately increase the wealth of shareholders (Hashat Khodaei, 2019). Investors and participants are seeking to identify suitable options and companies for investment in order to obtain appropriate returns according to their investment horizon and risk tolerance. The constant concern of the operators of the capital markets is to get sufficient and timely information to these markets in order to help the investors in order to analyze the securities and shares available in these markets while making important economic decisions. The lack of sufficient and reliable information and their unequal distribution in these markets will lead to poor decisions by the participants in these markets and the suboptimal allocation of their financial resources, which is known as information asymmetry in the accounting literature (Kermir et al. [10], 2009).

Asymmetric information is an important and discussed issue in financial literature. In the book of financial accounting theory by William R. Scott [11], information asymmetry is defined as follows: "The informational advantage of some parties to the transaction over others in a business transaction is called information asymmetry." He continues that without a doubt, information asymmetry is the most important concept of financial accounting, the first effect of the presence of asymmetric information is to disrupt the correct functioning of the markets, and information asymmetry may cause differences in the market value with the current value. According to Bron [12] (2007), information asymmetry occurs when a number of investors have more information about the company than the public has. Based on this, different parties involved in the market have different inferences from the prices of the companies' shares. In fact, the existing asymmetry is mainly caused by the difference in the time of receiving information between different groups, including people inside and outside the organization, or among investors themselves.

According to the information asymmetry model presented by Copeland and Galli [13] (1983) and Milgrom and Glostin [14] (1985), two types of traders can be imagined in the market: a) cash traders b) informed traders. Informed traders trade because they have confidential information that is not reflected in prices, while cash traders (uninformed investors) trade only because they have liquidity. Of course, these models refer to the relationship between the difference in buying and selling prices and informed people in the market. According to this model, the information asymmetry in the market leads to an increase in the range of the proposed purchase and sale prices.

The competitive levels of the market are among the important factors affecting the information asymmetry and, as a result, the cost of capital. When the capital market is non-competitive, companies with a high degree of information asymmetry have a higher cost of equity than companies with a low degree of information asymmetry. When the market is competitive, at any point in time, buyers and sellers know the stock price. In other words, the more competitive the capital market is, companies with a high degree of information asymmetry will have a smaller difference in the cost of equity compared to companies with a low degree of information asymmetry, and therefore, information asymmetry will not be a determining factor in determining the cost of equity (Khani and Ghajavand, 2013). They are not aware of information asymmetry. Therefore, this research examines the relationship between information asymmetry and the cost of equity in companies listed on the Tehran Stock Exchange.