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Managing The Information Cost of Financing
Managing The Information Cost of Financing
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.
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.
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1986
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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-
CHART 1
REDUCING THE INFORMATION COST OF FINANCING
Is the problem:
(A)
(B)
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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
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8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
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