%0 Journal Article
%T Correcting for Hubris in Project Appraisal
%A Jacques A. Schnabel
%J ISRN Economics
%D 2012
%R 10.5402/2012/478485
%X Behavioral finance research stresses the prevalence of overconfidence in capital budgeting practices. To remedy this shortcoming, specifically the upward bias in cash flow forecasts, the extant literature emphasizes the reduction of such forecasts. This paper considers the conditions under which a different adjustment is warranted, namely, an upward correction in the hurdle rate employed to evaluate the project. It is argued here that if adverse events can have a long-term, versus a merely transitory, deleterious effect on the project's cash flows, the second adjustment is appropriate. 1. Introduction A recurring theme in the behavioral literature on corporate finance is the endemic presence of hubris in the project appraisal process, that is, excessive optimism mars capital budgeting practices. As an antidote for the foregoing, numerous researchers have advanced procedures for correcting the cash flow projections associated with an investment proposal for this upward bias. This paper argues that, if adversity has a merely temporary effect on a project, a downward adjustment to the initial cash flow estimates suffices. However, if the adversity is of a more persistent nature, a second modification, namely, an upward revision of the discount rate, is apposite. The next section reviews the literature on managerial overconfidence in capital budgeting and develops a simple paradigm, labelled here ¡°an adversity sensitized NPV" (Net Present Value), for evaluating the adequacy of existing bias correction procedures. The succeeding two sections consider distinct scenarios where adverse events threaten the success of an investment undertaking. On the one hand, an unfavorable event may be merely transitory, affecting the cash flow of the project for solely one year, that is the year of the event's occurrence. On the other hand, the event may inflict permanent harm to the project affecting all the proposal's cash flows subsequent to the event's occurrence. In the former case, a reduction in the initial cash flow forecasts is adequate. However, in the latter case, the requisite adjustment is different, namely, an increase in the hurdle rate to reflect the probability of the adversity. 2. Hubris in Project Evaluation A leitmotif in behavioral investigations of capital budgeting practices is the notion that such decisions are biased by overconfidence and excessive optimism. This notion occupies a central place in various treatments of the topic, be it in the popular press, as exemplified by Lovello and Kahneman [1], or in behavioral finance textbooks such as Shefrin
%U http://www.hindawi.com/journals/isrn.economics/2012/478485/