Abstract
This paper extends the standard model of real option by allowing managerial biases originating from the cognition about the economic states in the future to examine the impacts of internal liquid funds on the firm’s investment decisions. The model indicates that the interactions between the cognition biases and firm’s volatility determine the extent to which the manager overestimates the growth rate, hence subjectively overvalues the firm’s value and distorts the investment decisions. The managerial cognition biases enhance the sensitivity of corporate investment to cash flow and increase the convexity of the investment decisions against the firm’s volatility. Relying on the amount of internal liquidity, the manager with cognition biases can both delay and expedite investing.
Highlights
Many financial economists have exerted great efforts to studying the interactions between corporate investment and financing strategies by assuming that the firm’s managers are fully rational, largely ignoring common personality traits of managers in modeling the complex decision-making process of corporate executives
In this paper, based on the standard theories of real options, we develop a continuous-time model with managerial cognition biases associated with the firm’s cash flow in the future to investigate the impacts of internal funds on the firm’s investment decisions and provide closed-form solutions for the relationship among the managerial cognition biases, the internal funds and investment strategies
Our model shows that the interactions between the biased cognition of the manager and the firm’s volatility determine the extend to which the manager with cognition biases overestimates the growth rate and the consequent valuation of the firm
Summary
Many financial economists have exerted great efforts to studying the interactions between corporate investment and financing strategies by assuming that the firm’s managers are fully rational, largely ignoring common personality traits of managers in modeling the complex decision-making process of corporate executives. (2016) Impacts of Internal Financing on Investment Decisions by Managers with Cognition Biases. In this paper, based on the standard theories of real options, we develop a continuous-time model with managerial biases originating from the manager’s cognition about the economic states in the future to investigate the impacts of internal liquid funds on the firm’s investment decisions. By incorporating the managerial cognition biases and indicating the corresponding effects on firms’ investment decisions, it extends the study on real options developed by [10]-[12]. By employing the definitions of optimism and overconfidence in [4]-[6] looks at the impacts of internal financing on investment decisions undertaken by an optimistic and overconfident manager.
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