Chapter 4 – Capital Budgeting
Chapter Four
Capital Budgeting
OVERVIEW
Chapter 4 describes how in practice managers make decisions about capital
budgeting, both for new projects and existing projects. The chapter focuses on the
following behavioral phenomena which impact managers’ capital budgeting decisions:
1. excessive optimism;
3. affect heuristic;
LEARNING OBJECTIVES
The main objective of this chapter is for students to demonstrate that they can identify the
manner in which biases and framing adversely impact managers’ forecasts of project cash
flow forecasts and their decisions about project adoption and termination. After
completing this chapter students will be able to:
1. Explain why excessive optimism and overconfidence lead managers to adopt negative
Chapter 4 – Capital Budgeting
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example involving two aircraft manufacturers, Boeing and Airbus, is used to introduce
the concept.
Excessive Optimism and Overconfidence
Section 4.3 presents a series of examples to illustrate excessive optimism and
overconfidence in a variety of different types of projects. Excessive optimism is a widely
documented phenomenon in both public sector projects and private sector projects.
Excessive optimism has many root causes. The first is perceived control, the same
phenomenon that encourages overconfidence. Additional behavioral phenomena that
appear to encourage excessive optimism are familiarity, representativeness, desirability,
and anchoring and adjustment.
Page 91 contains an important discussion about whether agency issues or biases
are the root cause of excessively optimistic, overconfident forecasts associated with
Overconfident managers underestimate risk. As a result they are inclined to
overestimate the value of adopting projects. There are two behavioral phenomena that
exacerbate overconfidence in respect to capital budgeting. The first is perceived control.
Chapter 4 – Capital Budgeting
As it happens, this phenomenon is strongest for white males who trust experts in general
and engineers in particular.
people will tend to be overconfident about their judgments. This phenomenon is called
the “illusion of validity.” Capital budgeting is typically a difficult task, in which the
specific details of proposed projects are salient, while the weight (statistical reliability) of
the available information is not considered explicitly.
In respect to corporate nudges, one way to mitigate the impact of the planning
fallacy is for managers to adopt an outside view in addition to their normal inside view.
The inside view focuses attention on the details of the project, or in other words the
strength of the associated information. The outside view asks managers to compare
Chapter 4 – Capital Budgeting
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sector decisions in history. The managers at Motorola who made that adoption decision
did so quickly, on the basis of their own intuition without any formal analysis.
The purpose of Concept Preview Question 4.2 on page 97 is to help students think
about the difference between choice and value. In answering the question, many students
will exhibit preference reversal, in that they will attach a lower value to the alternative
that they select than to the alternative that they reject. The most common pattern is for
students to choose A over B but value B more highly than A. Instructors should identify
the main point for students, namely that people’s thought processes for making choices
are not the same processes for engaging in valuation. Therefore people’s judgments about
choice and value can be in opposite directions.
The events in respect to Iridium are a case in point. The second behavioral
phenomenon is availability. It is difficult, if not impossible, to imagine every
Reluctance to Terminate Losing Projects
Aversion to a sure loss makes it difficult for managers to terminate losing
projects. Concept Preview Question 4.3 on page 99 is intended to set the stage, showing
that many people prefer to try and beat the odds than to accept a sure loss. The question
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classroom. No reproduction or further distribution permitted without the prior written consent of
McGraw-Hill Education.
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The first example used to illustrate the reluctance to terminate a losing project
comes from the firm Sony, and refers to a situation that took place in the 1960s when
Sony was developing color television technology. In addition to aversion to a sure loss,
the example serves to illustrate several other behavioral phenomena, such as
overconfidence, excessive optimism, visibility, and regret.
Notably, the key manager at Sony who resisted terminating the firm’s losing color
Confirmation Bias: Illustrative Example
A second example of aversion to a sure loss involves the pharmaceutical firm
Syntex. This example emphasizes the role of confirmation bias in the decision to continue
the development of a new drug. The key manager who resisted terminating Syntex’s
Managers can help themselves face the difficult decision to terminate a losing
project by asking themselves a series of focused questions.
Chapter 4 – Capital Budgeting
TEACHING TIPS FOR POWERPOINT SLIDES
Before showing the first PowerPoint slide, instructors might ask students to keep
in mind that traditional textbooks in corporate finance emphasize NPV as the primary
Slide 8
Slide 8 makes the point that excessive optimism in public sector projects has a
long history. The studies that are discussed relate military projects and to transportation
projects. Whether the issue is missile development or a military campaign, cost
underestimation is systematic and large.
Slides 9-11
Slide 9 pertains to excessively optimistic capital budgeting in the private sector.
After describing the results described in the slide, instructors might mention that studies
involve systematic optimism for all kinds of firms: pharmaceutical firms, tunnel
operators, mining firms, and software developers. Instructors might highlight the example
featuring the Channel Tunnel to make the point. The Standish Group study results,
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displayed in slides 10 and 11, on software and information technology projects describe
the magnitude of specific biases.
Slide 12
Slide 12 describes differing viewpoints about the reasons for cost overruns in
transportation projects. Some who study transportation projects, such as Bent Flyvbjerg,
contend that the reasons are entirely due to agency conflicts, and that optimistic project
cash flows are a manifestation of lying. Others, such as John McCready, disagree
Slide 14
Slide 14 presents the key issues in the example of Iridium, the subject of the first
Behavioral Pitfalls box in the chapter. Instructors might wish to emphasize that Motorola
chief executive officer (CEO) Robert Galvin asked for no formal analysis before
approving the project. In doing so, Galvin relied on the affect heuristic, basing his
decision on how good he felt about the project.
Chapter 4 – Capital Budgeting
engineers presenting the idea of a worldwide telephone network were able to paint a good
picture, having done so would increase the chances of their proposal being viewed
favorably.
Overconfident managers find themselves surprised more frequently than they
imagined. In the case of Iridium, Robert Galvin admits being surprised by the degree to
which cell phones had come to be used worldwide. Other surprises included the difficulty
with which Iridium phones worked indoors.
Slide 17
Slide 17 describes some of the psychological phenomena that contribute to
excessive optimism and overconfidence. Managers who perceive that their level of
control is high tend to be excessively optimistic. Instructors might ask students if
Chapter 4 – Capital Budgeting
also inclined to be excessively optimistic. Instructors might ask students if they believe
that these comments apply to Motorola CEO Robert Galvin in connection with Iridium.
probabilities of several outcomes, and unless managers really do the multiplication
computation carefully, they will be inclined to extrapolate from the first product or two.
This leads to a form of conjunction fallacy, the inappropriate computation of the
probability of several events occurring in conjunction.
Slide 17 points out that overconfident managers tend to underestimate project
risk. There are two behavioral phenomena that encourage overconfidence. The first is
perceived control. The more control managers perceive they exercise over a project, the
more overconfident they tend to be. One psychological study finds that overconfidence is
Chapter 4 – Capital Budgeting
events called Other Events, are prone to underestimate the chances that one of these
events will occur.
Slide 18
Slide 4 provides an example of availability bias in respect to judging the riskiness
of earnings. Risk managers are more familiar with property-related hazards. Financial
executives are more familiar with hazards that are associated with improper management.
Slide 19
Slide 19 describes one of the main findings of the survey conducted jointly by
Duke University and FEI about the criteria that financial executives report that they use
when engaged in capital budgeting. The findings are encouraging in that 75 percent of
executives report that they use NPV, and that they consider the issue to be important.