This paper uses a time-state-preference valuation model to examine how the firm's choice of technology and production method affects its equilibrium level of risk and, as a result, the firm's cost of capital. A fixed and flexible method of production is analyzed for a firm using a Cobb-Douglas production function. In both cases, it is found that risk and the cost of capital decrease with the level of capital intensity. Implications are drawn for the specification of empirical tests of the determinants of risk.

The purpose of this paper is to determine the correct procedure for discounting cash outflows in a capital market context. Beedles has stated flatly that “the risk adjusted discount (RADR) approach should not be applied to investment projects with negative benefits” ([1], p. 176). Lewellen also has recently examined the problem because he felt that there “is something at least vaguely disturbing about the associated write-down of the present value of cash outflows for risk” ([7], p. 1332). Lewellen, however, concluded that “the standard procedure used for inflows can therefore be transferred intact. The logic is symmetric because the sign of the flows is reversed.” In a comment on Lewellen, Celec and Pettway stated that they are “in substantial disagreement with Lewellen's development as well as with any implied generality of employing the standard RADR procedure in valuing cash outflow streams” ([3], P. 1061). This inappropriateness of the standard RADR approach to valuing cash outflows seems to have been accepted in the 1iterature. Kudla [6] recently claimed that it has been proved by the above authors and others that the normative rules in capital budgeting do not hold in evaluating cash outflows.

We find that firms that regularly access public debt (bond) markets are more likely to pay a dividend and subsequently follow a dividend smoothing policy than firms that rely exclusively on private (bank) debt. In particular, firms with bond ratings follow a traditional Lintner (1956) style dividend smoothing policy, where the influence of the prior dividend payment is very strong and the current dividend is relatively insensitive to current earnings. In contrast, firms without bond ratings flow through more of their earnings as dividends and display very little dividend smoothing behavior. In effect, they seem to follow a residual dividend policy.