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.

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Document Object Identifier (DOI): 10.3386/w5496

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

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