NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Rational Capital Budgeting in an Irrational World

Jeremy C. Stein

NBER Working Paper No. 5496*
Issued in March 1996
NBER Program(s):   AP    CF

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.

*Published: Journal of Business, vol.69, no.4, October 1996, pp. 429-455.

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