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Rational Capital Budgeting in an Irrational World

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  • Stein, Jeremy C

Abstract

This article addresses the following basic capital budgeting problem: 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? The author shows 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. Copyright 1996 by University of Chicago Press.

Suggested Citation

  • Stein, Jeremy C, 1996. "Rational Capital Budgeting in an Irrational World," The Journal of Business, University of Chicago Press, vol. 69(4), pages 429-455, October.
  • Handle: RePEc:ucp:jnlbus:v:69:y:1996:i:4:p:429-55
    DOI: 10.1086/209699
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