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BCF Lecture 4: Capital Budgeting" combined
Terms in this set (46)
Traditional capital budgeting methods, and how to CEOs generally allocate capital?
NPV, IRR, and payback rule
Capital allocation: Lot of it depends of confidence, gut feel and NPV Rank
Why would overconfidence influence capital budgeting decisions?
Capital budgeting decisions often complex and it is difficult to learn from previous capital budgeting decisions
take credit for positive outcomes and blame external factors for negative outcomes
more confident managers are more likely to apply for a job as CEO
How do overconfident managers underestimate risk/uncertainty when making investment decisions
They underestimate the cost of capital
There is a greater possibility to invest in negative NPV projects
External funds are perceived as unduly costly
They forgo investment when dependent on external equity
They are Less inclined to postpone the decision to undertake project
They Expend more effort than rational managers
Possible solutions to overconfidence in capital budgeting
Increase hurdle rates
No stock option compensation for highly overconfident managers
What are systematic biases in forecasts?
Post-audits done only for accepted projects, which are most likely optimistically biased
Original Forecast is optimistically biased if proportion of available bad projects is greater than that of good projects to choose from
Millers hypothesis in capital budgeting?
Decision-makers use their experience to modify forecasts to reduce/eliminate optimistic bias
Results of Statmans capital budgeting article
Both costs and sales are considered to be optimistically biased
Bias stronger for sales forecasts than for costs forecasts
Effect is stronger for more experienced participants
Psychological determinants of excessive optimism
Control, Familiarity, Desirability and wishful thinking, Anchoring and adjustment
Agency: Empire Building, Compensation
Preference Reversal (review with chart)
Value versus choice
Individuals tend to:
Value lotteries with a small chance of winning a large prize higher than lotteries with a high chance of winning a low prize (i.e., B over A)
prefer lotteries with a high chance of winning a low prize over lotteries with a small chance of winning a large prize (i.e., A over B)
What does preference reversal mean for managers?
When relying on intuition/affect, managers may select projects with lower values than projects with higher values
Possibility of non-value maximizing behavior
What is the sunk cost fallacy and what does prospect theory say about it?
Sunk cost fallacy: Managers are not willing to terminate a project given their cumulative prior investments
Prospect theory: sunk cost provides different reference point
"Realization" of losses rather than "unrealized paper" losses brings about the emotion of regret
Kahneman and Tversky (1982): "regret is felt if one can imagine having taken an action that would have led to a more desirable outcome"
Having to take the responsibility intensifies the experience of regret
Negative consequences can cause decision makers to increase the commitment of resources and undergo the risk of further negative consequences
Justify prior behavior
Demonstrate ultimate rationality of original course of action
Lower likelihood to terminate a losing project resulting in "throwing good money after bad"
Visibility enhances escalation of commitment; true or false
Some positive effects of overconfidence?
-Lower cost of equity (if market buys it)
-More effort than rational managers
-Less inclined to postpone the decision to undertake project
What biases are associated with capital budgeting
Overconfidence, affect heuristic, confirmation biases, excessive optimism
What do sunk costs say about risk averse managers?
Risk averse managers who accept their losses are more likely to abandon the project
How is overconfidence good for innovation?
New and innovative projects are risky—so managerial overconfidence could potentially be important.
Because outcomes of innovative projects take a while to resolve, overconfidence tends to be even more severe since there is deferred feedback.
• Firms with overconfident CEOs have:
- Greater return volatility
- More investment in innovation
- More innovative success
How do overconfident managers deal with risk?
Overconfident managers are more willing to undertake risky projects because they expect to succeed in risky environments.
Risk taking is measured by realized stock return volatility.
Main hypothesis of Hirshleifer when it comes to risk
Firms with overconfident managers accept greater risk, invest more heavily in innovative projects, and achieve greater innovation.
Overconfidence and innovative activity
Firms with overconfident CEOs are associated with higher expenditures on R&D
Firms with overconfident CEOs are associated with a higher number of patents and more patent citations
Results: Overconfidence and firm value
The interaction between options based overconfidence and growth opportunities is positive and significant for the full sample and the innovative subsample
For press based overconfidence, the results are not significant
Results: Overconfidence and innovative efficiency?
For given levels of R&D, overconfidence significantly increases innovative output in innovative industries
For non-innovative industries, no significant relationship is found
Results: Overconfidence and stock return volatility
Stock return volatility is significantly higher for both measures of CEO confidence
What does CEO overconfidence say about shareholder value?
- Overconfidence associated with greater likelihood of earnings management and financial fraud
- Overconfident managers tend to make more acquisitions, overpaying for these, and receive negative market reactions
• More acquisitions do not necessarily translate to higher firm value
Why is overconfidence good for innovation?
Key point: New and innovative projects are risky—so managerial overconfidence could potentially be important.
In what feedback setting does overconfidence thrive in?
Because outcomes of innovative projects take a while to resolve, overconfidence tends to be even more severe since there is deferred feedback. Overconfidence is severe in settings with ambiguous & deferred feedback, not direct.
What is the main hypothesis of Hirshleifer?
We hypothesize that firms with overconfident managers accept greater risk, invest more heavily, and achieve greater innovation.
What are the proxies used by Hirshliefer?
The proxies used are exercise prices of options and word counts related to overconfidence.
Measured by level of R&D expense and number of patent and citation count.
Why is greater innovation only achieved in innovative industries?
• Overconfidence helps exploit innovative growth opportunities
What is a selection bias when it comes to preparing budgets?
Post-audits are conducted only for projects that are accepted, and acceptance is more likely if costs were underestimated and sales were overestimated. Therefore, the audited group could contain more projects that turn out worse than forecasted than would the group of rejected projects. So just the fact they were accepted shows bias.
What does Statman conclude work experience?
The results of our experiment suggest that people with work experience believe that forecasters tend to submit optimistic of forecasts: They do so out of experience.
Do decision makers adjust sufficiently for biases?
NO! Bias still exists!
Are decision makers' assumptions always correct about forecasts?
Decision makers may incorrectly assume that the forecasts are optimistically biased. This error may occur if decision makers misinterpret post-audit results by ignoring the fact that post-audits are performed on accepted projects but not on rejected projects.
Why is NPV not intuitive to a lot of people?
Because people dont think of NPV as incremental wealth that aproject generates for investors; they think of it in formula format.
Choosing low-value alternatives over high-value alternatives; it happens because people use adifferent mentalprocess to make a choice than they do access value. Like the chance of winning generates a more emotional response than the amount won. So managers are prone to selecting projects with lower values in place of projects with higher values
Two main contributors to overconfident decisions about capital budgeting
1. Perceived control
2. Inadequate planning and risk management. When they do it themselves, they are overconfident.
Excessive optimism in capital budgeting
Upwardly biased forecasts.
The psychological determinants of excessive optimism in capital budgeting
1. Perceived control
2. Familiarity with situation
3. Desirability and wishful thinking (the more the desirability of the outcome, the more optimistic people become)
4. Anchoring and adjustment, the Conjunction fallacy: Miscalculating the probability of an event that is defined as the conjunction or simultaneous occurrence of a series of separate events.
Equation for Statman and what does a W of .5 (bigger of smaller mean?)
E = UW + (1-W)L
where L is the low forecast
W is the relative weight assigned to high forecast
E is the forecast of decision maker
A W < .5 means optimistic bias for revenues
A W > .5 means optimistic bias for costs
Does Statman find biases that are real or perceived?
The optimist bias found in post-audits may indeed be perceived, arising from failure to measure difference between forecasts upon which decisions are made, and actual costs or sales.
Does Statman think that decision makers assume correctly about biases?
No, not always.....Decision makers may incorrectly assume that the forecasts are optimistically biased.
This error may occur if decision makers misinterpret post-audit results by ignoring the fact that post-audits are performed on accepted projects but not on rejected projects.
What are the four results of Hirschleifer on overconfidence
Stock return volatility
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