Overconfidence and Optimism in Capital Budget Decisions: Corporate Finance from a Behavioral Point of View

Zain Ullah, Shams Ur Rehman, Muhammad Nisar Khan

Abstract


This article, as a result of the literature review carried out, presents a comparative analysis between the process of evaluating investment decisions, from traditional financial theory, and a new complementary approach arising from corporate finance. based on behavior (Behavioral Corporate Finance), a growing field of research in which emotional and cognitive influences are incorporated in order to achieve a better understanding of business decision-making. In particular, the way in which behavioral biases, so called overconfidence and optimism, systematically influence the capital budgeting process is analyzed. Empirical evidence shows that these biases lead to overestimating expected net cash flows and underestimating their variances, which mainly results in sub-optimal financial decisions (i.e. overinvestment and excessive exposure to risk), although they sometimes also originate practices that contribute to value of the company (i.e. speed in the execution of projects and greater commitment). The paper proposes recommendations to correct the distortions that the psychological biases of overconfidence and optimism generate about the capital budgeting process.


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