Working Paper: NBER ID: w5496
Authors: 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.
Keywords: No keywords provided
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Managerial time horizons (D25) | Optimal hurdle rates (G19) |
| Financial constraints (D10) | Optimal hurdle rates (G19) |
| Market inefficiencies (G14) | Optimal hurdle rates (G19) |
| Inefficient stock market (G14) | NEER approach (F11) |
| Low book-to-market ratio (G19) | NEER approach (F11) |
| Low expected return (G19) | FAR approach (Y20) |
| CAPM (O22) | Fundamental economic risk (G19) |
| Short time horizons (C41) | CAPM (O22) |
| Financial constraints (D10) | CAPM (O22) |