Investment decisions, net present value and bounded rationality

Magni, Carlo Alberto (2007): Investment decisions, net present value and bounded rationality. Forthcoming in: Quantitative Finance

Abstract

TThe Net Present Value maximizing model has a respectable ancestry and is considered by most scholars 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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Finance, Investment decisions, Net Present Value, heuristics, bounded rationality, cognition
• Subjects: D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D81 - Criteria for Decision-Making under Risk and Uncertainty; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; B - History of Economic Thought, Methodology, and Heterodox Approaches > B4 - Economic Methodology > B40 - General; G - Financial Economics > G3 - Corporate Finance and Governance > G31 - Capital Budgeting ; Fixed Investment and Inventory Studies ; Capacity; A - General Economics and Teaching > A1 - General Economics > A12 - Relation of Economics to Other Disciplines; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M2 - Business Economics > M20 - General; G - Financial Economics > G3 - Corporate Finance and Governance > G30 - General

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