Capital investment decision, corporate governance, and prospect theory

Abstract

This paper investigates whether the effects of prospect theory exist in the decision making of corporate capital investment via the value function of cumulative prospect theory proposed by Tversky and Kahneman (1992). With a reference point of firm performance, the change in annual capital investment ratio is taken as the proxy variable for value which reflects the utility obtained from gains or losses. By adopting the value function as the empirical model, irrational behavior of risk aversion, risk seeking, and loss aversion is observed. Besides, the evidences show that financial constraints cannot change the behavior of risk aversion when firms are facing gains, but the irrational behavior cannot be observed when variables of corporate governance structure are included, i.e. the corporate governance mechanism is functioning. On the other hand, no behavior of risk seeking is observed when firms are facing losses with the consideration of financial constraints or corporate governance.