Rational Capital Budgeting in an Irrational World

46 Pages Posted: 13 Jul 2000 Last revised: 30 Sep 2010

See all articles by Jeremy C. Stein

Jeremy C. Stein

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

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Date Written: March 1996

Abstract

This paper addresses the following basic capital budgeting question: Suppose that cross-sectional differences in stock returns can be predicted based on variables other than beta (e.g., book-to- market), and that this predictability reflects market irrationality rather than compensation for fundamental risk. In this setting, how should companies determine hurdle rates? I show how factors such as managerial time horizons and financial constraints affect the optimal hurdle rate. Under some circumstances, beta can be useful as a capital budgeting tool, even if it is of no use in predicting stock returns.

Suggested Citation

Stein, Jeremy C., Rational Capital Budgeting in an Irrational World (March 1996). NBER Working Paper No. w5496. Available at SSRN: https://ssrn.com/abstract=225524

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