Biases and framing adversely impact the behavior of managers when they formulate
forecasts of project cash flows and make decisions about both project adoption
and project termination. Managers who do not undertake discounted cash flow
analysis for the purpose of capital budgeting are vulnerable to preference
reversal, in that they select low-value projects over high-value projects.
Overconfidence leads managers to underestimate project risk. Excessive optimism
leads managers to establish cash flow forecasts that are upwardly biased. The
combination of aversion to a sure loss, regret, and confirmation bias leads
managers to continue a failing project when they should terminate the project. Managers display excessive optimism for many reasons. Managers typically exaggerate
the degree to which they can control events. They might establish forecast
ranges but set expected cash flows at the top end of the range. If the success
of a project depends on the conjunction of several events, then anchoring may
lead managers to overestimate the probability of the conjoined event that
defines success. In forming their own judgments about project success, managers
may become anchored on the forecasts of those proposing the project and fail
to adjust sufficiently from that anchor. These issues pertain to the inside view.
Managers might be able to mitigate excessive optimism by adopting an outside
view. However, adopting an outside view does not come naturally to managers. Behavioral
impediments are not the same as agency conflicts. The remedy for agency
conflicts involves the alignment of incentives between principal and agent.
Behavioral phenomena need to be addressed using debiasing techniques. |