Rational Capital Budgeting in an Irrational World

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.