Review of Accounting Studies, 9, 261–264, 2004
# 2004 Kluwer Academic Publishers. Manufactured in The Netherlands.
Discussion of ‘‘The Role of Information Precision in
Determining Cost of Equity Capital’’
MICHAEL WILLIAMS email@example.com
Anderson Graduate School of Management, University of California, Los Angeles, CA 90095
Abstract. Botosan, Plumlee, and Xie (this issue) demonstrate an association between a proxy for cost of
capital and proxies for public and private information precision. These proxies have limitations that
suggest caution in interpreting their results, absent evidence of proxy validity. The proxy for cost of capital
is based on Value Line’s beliefs about expected returns, not actual expected returns. The proxy for private
information measures information revealed by analysts, not information used by inside traders.
In this paper, Botosan, Plumlee, and Xie (this issue; hereafter BPX) empirically explore the joint effect
that public and private information precision have on the cost of equity capital. Their key ﬁndings are that
more precise public information lowers the cost of capital, while more precise private information raises
the cost of capital. The paper considers whether public and private information are substitutes or
complements but ﬁnds no evidence of an interactive effect.
This is an important question with signiﬁcant policy implications for ﬁrms, investors, and regulators.
While there is (as the authors discuss) considerable prior literature on the topic, the matter is empirically
unsettled, so further evidence is welcome. Also, the authors make an important point that, given the
correlation between public and private information, it is essential to control for one when analyzing the
effect of the other.
The reliability of the results in BPX depends on whether the proxies used in the paper effectively
measure the underlying economic constructs. Cost of equity capital is proxied by a formula using Value
Line forecasts, while public and private information measures are based on analyst forecast dispersion and
accuracy. Most of the following discussion considers how reliable these proxies might be.
1. Cost of Equity Capital Proxy
The proxy for cost of equity capital, r
, is a construct that equals the implied
equity premium for a stock based on its current price, forecasted future dividends,
and forecasted future price. The forecasts are taken from Value Line. This is a
measure of what Value Line expects the return on the stock will be (net of the risk-
free rate), rather than the actual expected return. Any properties of the measure are a
function of Value Line’s beliefs, not necessarily reality.
The measure presumes that expected returns depend only on cost of capital and
risk premia, with no abnormal returns. That might be true of actual expected
returns, but there is no reason to assume that Value Line does not factor abnormal
returns into its price forecasts. After all, the job of an analyst is to identify under-
and over-valued ﬁrms. The inclusion of abnormal returns in r