The Effect of Real Options Training on Managers’ Risk Perceptions and Decision Models

Abstract

Academic and practitioner literature has advocated the use of real options rather than traditional discounted cash flow valuation techniques, claiming that doing so results in better decisions about long-term investments. However, we know little about how managers perceive projects that include a portion of value from real options, or how training in real options valuation affects those perceptions. This paper investigates how managers perceive the riskiness of projects that are valued using real options valuation techniques. We conduct an experiment in which graduate students act as supervisors who evaluate proposals for long-term investment projects submitted by subordinates and decide how much funding to provide to each. We vary the extent of real options training provided before the task. We investigate perceived risk in two dimensions: the perceived risk of loss, and the perceived risk of high variance in project outcomes. We predict and find that supervisors’ perceptions of the relative risk of loss in projects differ depending on the extent of training provided. However, we find that supervisors’ perceptions of the relative risk of high variance in project outcomes do not differ across training types, contrary to expectations. We also predict and find that more extensive training prompts supervisors to weight risk perceptions more heavily in funding decisions, and provide evidence that such training also prompts supervisors to adopt more complex decision models. This study contributes to limited prior literature on how supervisors react to real options values when they are provided for decision-making and on individuals’ perceptions of different dimensions of risk, and to firms’ cost-benefit analyses of adopting real options valuation.