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

Abstract

As result of the literature review carried out as a research project, this article presents a comparative analysis of the evaluation process of investment decisions from the viewpoint of the traditional financial theory and a new complementary approach that arises from Behavioral Corporate Finance, a growing research field which incorporates emotional and cognitive influences with the purpose of obtaining better understanding with respect to corporate decision making. In particular, we analyze the way that behavioral biases, called overconfidence and optimism, systemically influence the process of capital budgeting. Empirical evidence shows that these biases lead to overestimating the expected net cash flows and underestimating their variances, resulting mainly in sub-optimal financial decisions (i.e. overinvestment and excessive exposure to risk.), although they occasionally create practices that add value to the company (i.e. speed in the execution of projects and greater commitment). The paper makes recommendations aimed at correcting distortions that psychological biases of overconfidence and optimism generate on the capital budgeting process