Technology Adoption, External Financing Friction, and the Cross Sectional Returns

Abstract

We explore the asset pricing implications of technological change in a model with costly technology adoption and external financing frictions. Firms adopt the latest technology embodied in new capital to reach the technology frontier, but entail adoption costs and external financing costs. The central finding is that optimal technology adoption is an important determinant of the cross section of stock returns. The model predicts that technology adopting firms are less risky than non-adopting firms. Intuitively, by restricting firms from freely upgrading the existing vintage capital to the technology frontier, costly technology adoption and external financing frictions reduce firms' real and financial flexibilities, and hence generate the risk dispersion between technology adopting firms and non-adopting firms. The model is qualitatively and in many cases quantitatively consistent with the key empirical regularities in the cross sectional returns.