Investment decisions, net present value and bounded rationality

Abstract

The Net Present Value maximizing model has a respectable ancestry and is considered by most scholars to be a theoretically sound decision model. In real-life applications, decision makers use the NPV rule, but apply a subjectively determined hurdle rate, as opposed to the ‘correct’ opportunity cost of capital. According to a heuristics-and-biases-program approach, this implies that the hurdle-rate rule is a biased heuristic. This work shows that the hurdle-rate rule may be interpreted as a fruitful strategy of bounded rationality, where several domain-specific and project-specific elements are integrated and condensed into an aspiration level. The paper also addresses the issue of a productive cooperation between bounded and unbounded rationality.

Keywords:

• Corporate finance
• Investments
• Bounded rationality
• Valuation
• Cognition and economics

Acknowledgements

The author wishes to thank Nathan Berg for his invaluable remarks and suggestions.

Notes

†A precursory example of the use of NPV for valuing real options may be found in Merrett and Sykes (1973, p. 129).

†All following quotations from J&M (2002) refer to the Internet version.

‡Some other authors are puzzled by the “intriguing paradox” of such near-optimal choice behaviors: “we have compelling evidence that managers … often do not use real option techniques … On the other hand, strategic decisions under uncertainty appear to conform to some general expectations based on real option theory … The resolution of this paradox would seem to be that, despite their biases, managers’ strategic investment decisions can loosely conform to normative real options models. Managers may employ real option reasoning, without getting all the details correct … Managers’ investment decisions may be ‘directionally correct’, even if they are not completely unbiased” (Miller and Shapira 2004, p. 281). However, the authors admit that actual choice behaviors take account of variables disregarded by normative models: “normative models for pricing options overlook key aspects of the behavioral and organizational contexts in which investment decisions occur” (p. 282).

†“We do not suggest that managers should use these rules of thumb” (McDonald 2000, p. 30).

†The fuzzy-logic version of the NPV is a further recent addition to the numerous existing versions (Ward 1989, Chiu and Park 1994, Abdel-Kader et al. 1998, Buckley et al. 2002). Admittedly, the cognitive implications of a cost of capital and a NPV based on fuzzy logic are an open issue.

†“We also have some semantic problems defining exactly what is meant by the value of a non-traded project” (Smith and Nau 1995, p. 804, footnote 7).

‡Rubinstein's proposal is logically equivalent to other classical proposals presented in the late sixties and early seventies by such scholars as Mossin, Hamada, Tuttle and Litzenberger, Bierman and Hass (see Senbet and Thompson 1978 and Magni 2007b for a review).

†See also Haley and Schall (1979, pp. 182 and 183) for the unreliability of the disequilibrium NPV in ranking projects.

‡Magni (2007c) focuses on CAPM-based capital budgeting and shows that the derivative of the NPV function may be decreasing with respect to the end-of-period cash flow in some state of nature. Dybvig and Ingersoll (1982) focus on asset pricing and show that CAPM does not guarantee the absence of arbitrage in a security market.

§See Magni (2009) for an analysis of the notion of residual income.

†The implicit discount rate is 5% = (1/20) ∗ 100.