Behavioral Finance Indian School of Business

Applying Behavioral Finance to Capital Budgeting

Project Terminations

- Meir Statman and David Caldwell
Presentation Overview
Behavioral Finance Indian School of Business
1.) Abstract of the paper

2.) How people make decisions: Some basic behavioral insights

3.) Application of Insights- Project Termination Decisions

4.) Some examples and applications from the context of Behavioral Finance

5.) Conclusions

Abstract
Central Rule of capital budgeting prescribes :
Investment projects should be selected, continued or terminated based on NPV
Sunk costs should be ignored
Projects should be terminated when
E(cash flows)
project terminated today
> E(cash flows)
project continued for one additional period

Termination decisions are difficult even when they are wise
The paper explores why managers become entrapped into negative NPV projects and
throw good money after bad projects as they attempt to rescue them. The paper first
unravels a tendency to become entrapped and resist project terminations.
The second part of the paper describes structures, such as organizational hierarchies
and hostile takeovers, that are designed to overcome resistance to project
terminations

Behavioral Finance Indian School of Business
Insights: Behavioral Finance
Prospect Theory: Framing mental accounts and evaluating them
A person is involved in a business venture in which he has already lost $2,000. Now he faces a
choice between a sure gain of $1000 and an even chance to win $2,000 or nothing. What will he
choose?

Economic accounting Vs. Mental Accounting-Ignore Vs. Consider Sunk Cost
Economic accounting-$2,000 sunk cost be ignored and project be abandoned
Mental Accounting-The choice of closing the account with a sure loss of $1,000 is discarded
over the choice of closing the account with a loss of $2,000 or a loss of $0
Kahneman and Tversky argue that people display risk-seeking behavior when faced with a
choice between a sure loss and a gamble

Behavioral Finance Indian School of Business
Aversion to Regret

According to Kahneman, Tversky and Thaler people are reluctant to realize losses because
realization induces regret



Insights: Behavioral Finance
Regret
Availability of
choices
Reluctance to
violate standard
procedure
Reluctance to act
innovatively
Responsibility of
the final outcome
Behavioral Finance Indian School of Business
Behavioral Finance Indian School of Business
Insights: Behavioral Finance
Self Control Problem







Realization of loss Regret
Procrastination
Postpone the pain
Continue negative
NPV project
An intrapersonal agency conflict between a rational
forward looking principal and an emotional myopic agent
Link between personal responsibility for the initial
decision and the reluctance to realize losses in the later
stages

Behavioral Finance: Project Termination Decisions



Why Wasteful Commitment



Behavioral Finance Indian School of Business
Wasteful
Commitment
Temptations to rescue
the project
Sunk Cost: Counter
intuitive
Admire people who
persist
High rewards-success
High penalty-failure
Two faces of commitment
1.) Motivating face-Leads to accomplishing goals that seem impossibly remote
2.) Wasteful face- Leads to throwing good money after bad money
Behavioral Finance Indian School of Business
Project Termination Decisions
What can be done for better project termination decisions in firms

Formulation of projects-Economic Accounting (+ NPV)
Continuation contingent on periodic NPV comparison
Iron clad internal enforced rules to realize losses
Rules
Performed by the finance function
Absence of commitment to the project
Exposing rosy projections made by project champions
Enforcing Pre-commitment milestones
Anti Champions
Not Part of the main decision making process
Consultants-possess the objectivity and are not entrapped
Takeovers- A way to terminate losing strategies
Work out units
(Internal & External)
Incentivize accurate information for periodic audit
Reward people who disclose bad news early
Avoid acute penalties as they entrap project champions
Frame losses as gains (to avoid alienation of the manager)
Rewards & penalties
Concorde effect-British and French governments decision to
continue funding the joint development despite poor sales
Political implications and publicly admitting that all past expenses
on the project prevented either government from abandoning
the project.
Behavioral Finance Indian School of Business
Project Termination Decisions-Some examples
Shugart Company-Leader in disk drives
Started the project in 1980
Project abandoned in 1983 after severe time and cost overruns
Keeping the project going was a way to placate the people by
giving them more time to make it come out right and not admit
defeat-
Lockheed Martin: Started working on Tri-Star L1011
Program Terminated in 1981-Would have bankrupted the
company if not for a federal government bailout
Stock prices increased by 18% on the day of the termination
announcement

Conclusions
Behavioral Finance Indian School of Business
Key Insights
Mental Accounting takes sunk cost into consideration and hence project termination
becomes difficult
Availability of choice, individual responsibility accentuate the feeling of regret
High personal responsibility, high insecurity and high resistance to a decision lead to
increased commitment to previously chosen decisions
Consistent rather than experimental behavior is considered socially desirable
Procrastination: People tend to delay termination because of the fear of loss
realization
Periodic reviews, project audits by finance people, internal rules, pre-commitment,
alignment of rewards and penalties fear of take overs are used as tools for project
termination


Thank You
Behavioral Finance Indian School of Business
Group Members:
Akshun Gulati-61210522
Sidharth Gambhir-61210600
Shruti Singh-61210377
Amrit Singh-61210554