Rational Capital Budgeting in an Irrational World

J. OF BUSINESS, Vol. 69 No. 4, October 1996

Posted: 15 Jan 1997

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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Abstract

This article 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.

JEL Classification: G11, G12, G14

Suggested Citation

Stein, Jeremy C., Rational Capital Budgeting in an Irrational World. J. OF BUSINESS, Vol. 69 No. 4, October 1996. Available at SSRN: https://ssrn.com/abstract=8034

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