DECISION MAKING AND DISPLAY METHODS: THE CASE OF PRESCRIPTION AND PRACTICE IN CAPITAL BUDGETING

ABSTRACT

Surveys of businesses' capital budgeting practices reveal that the IRR is much preferred over the NPV as an investment decision making tool even though business scholars prescribe the NPV as theoretically optimal. Here practitioners' preference for the IRR is explained through ergonomics: the IRR is treated as a display method. As such it is more compatible with decision makers' expectations and therefore, is more cognitively efficient. Because the IRR is expressed as an interest rate, it more closely resembles an analog display, in which the IRR is simply compared to the required return. In contrast, the NPV is stated in dollars, resembling more a very precise digital display. Academicians should reorient their efforts from promoting the NPV to teaching methods to ameliorate the pitfalls of the IRR.

Notes

DORLA A. EVANS is Associate Professor of Finance at The University of Alabama in Huntsville. Her primary research interest is the application of the principles of behavioral finance and experimental methods to investment and corporate finance decisions. She is currently working on a National Science Foundation grant to study the effects of market discipline on violations of expected utility theory.

SHAWN M. FORBES is Associate Professor of Finance at Georgia Southern University. He received his Ph.D. at the University of Georgia. He has published several articles about the prime rate and is pursuing a research interest in behavioral finance