Informed trading, noise trading and the cost of equity

This paper develops a model where a firm (firm 1), managed by an insider, has to issue either debt or equity to finance a new project. When equity is issued, the investor purchasing it demands a premium over the risk-free rate to compensate for the risk of trading with informed traders in the future. The investor can freely allocate his liquidity trades between firm I and a second firm, firm 2, also managed by an insider. Each firm's stock is also traded by an informed trader who can disclose information to the public. Trading is as in [Kyle, A., 1985, Continuous Auctions and Insider Trading, Econometrica 53, 13 15-1335.], there is noise trading in firm 2's stock but not necessarily in firm 1's stock. We find that in the absence of noise trading in firm 1's stock, the informed trader in that stock has to dislcose more information to attract the investor's liquidity trades and this lowers firm 1's cost of equity. This result is reinforced when insiders are allowed to trade. (c) 2006 Elsevier Inc. All rights reserved.