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Rational Capital Budgeting in an Irrational World

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  • Jeremy C. Stein

Abstract

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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  • Jeremy C. Stein, 1996. "Rational Capital Budgeting in an Irrational World," NBER Working Papers 5496, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:5496
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