This paper examines the relation between information differences across investors (i.e., information asymmetry) and the cost of capital and establishes that with perfect competition information asymmetry makes no difference. Instead, a firm’s cost of capital is governed solely by the average precision of investors’ information. With imperfect competition, however, information asymmetry affects the cost of capital even after controlling for investors’ average precision. In other words, the capital market’s degree of competition plays a critical role for the relation between information asymmetry and the cost of capital. This point is important to empirical research in finance and accounting.

Prior literature predicts a positive relation between firms' expected pre-tax rates of return and investor-level capital gains tax rates. We show that this relation is more nuanced than suggested by prior literature and that in three circumstances the relation can actually be negative. The first circumstance is when a firm's systematic risk is very high. The second circumstance is when the market risk premium is very high. The third circumstance is when the risk-free rate of return is very low. The circumstances arise because, in addition to reducing investors' expected after-tax cash proceeds, capital gains taxes reduce the risk that investors associate with the expected after-tax cash proceeds.

Prior literature predicts a positive relation between firms' expected pre-tax rates of return and investor-level capital gains tax rates. We show that this relation is more nuanced than suggested by prior literature and that in three circumstances the relation can actually be negative. The first circumstance is when a firm's systematic risk is very high. The second circumstance is when the market risk premium is very high. The third circumstance is when the risk-free rate of return is very low. The circumstances arise because, in addition to reducing investors' expected after-tax cash proceeds, capital gains taxes reduce the risk that investors associate with the expected after-tax cash proceeds.