Rational Capital Budgeting in an Irrational World / Jeremy C. Stein.

By:

Stein, Jeremy C

Contributor(s):

National Bureau of Economic Research

Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w5496.Publication details: Cambridge, Mass. National Bureau of Economic Research 1996.Description: 1 online resource: illustrations (black and white)Online resources:

Available additional physical forms:

Hardcopy version available to institutional subscribers

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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Previous	nber w5493 Compensation Structure and Product Market Competition /	nber w5494 Determinants of Privatization Prices /	nber w5495 Explaining Domestic Content: Evidence from Japanese and U.S. Auto Production in the U.S. /	nber w5496 Rational Capital Budgeting in an Irrational World /	nber w5497 Getting Pegged: Comparing the 1879 and 1925 Gold Resumptions /	nber w5498 Pricing Strategy and Financial Policy /	nber w5499 Cash Flow and Investment: Evidence from Internal Capital Markets /	Next

March 1996.

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.