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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 P(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 tool, even budgeting if it is of no use in predicting stock returns.

Suggested Citation

  • Stein, Jeremy C., 1996. "Rational Capital Budgeting in an Irrational World," Scholarly Articles 3708373, Harvard University Department of Economics.
  • Handle: RePEc:hrv:faseco:3708373
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    References listed on IDEAS

    as
    1. Stein, Jeremy C, 1988. "Takeover Threats and Managerial Myopia," Journal of Political Economy, University of Chicago Press, vol. 96(1), pages 61-80, February.
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    12. Jeremy C. Stein, 1989. "Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 104(4), pages 655-669.
    13. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1989. "The Size and Incidence of the Losses from Noise Trading," Journal of Finance, American Finance Association, vol. 44(3), pages 681-696, July.
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