Factors Influencing Managers’ Decisions to Continue/Discontinue Capital Budgeting Projects

Abstract

Normative decision theories stipulate that rational economic decisions (including investment decisions) are made based on the assessment of the expected outcomes. Accordingly, if available feedback information about an investment project indicates at any given point in time that the expected outcome would be negative, one would expect that such an investment project would be immediately terminated. This implies that any prior funds spent on an investment project that cannot be recovered (known as sunk costs) are considered irrelevant to the decision to terminate. However, the decision-making literature provides instances of entrapment or escalation where decision makers were influenced by sunk costs in their decisions.The psychology literature provides two basic explanations for this entrapment or escalation behaviour. The first explanation attributes the escalation behaviour to the notion of self-justification and asserts that a decision-maker who is associated with the initial decision to invest in a project will elect to commit additional resources to the investment project as a way to justify past decisions, even when the available information indicates that the project should be terminated. The second explanation is rooted in prospect theory, which postulates that decision-makers tend to evaluate choices as gains and losses in relation to a neutral reference point and that decision-makers are generally risk seeking when faced with possible losses. That is, a risk-seeking person would reject a certain loss in favour of a gamble with equal or even “lower” expected value. Thus, for commitment escalation, the theory asserts that decision makers would view sunk costs as a sure loss and they would prefer to engage in the escalation of prior commitments with the possibility of incurring greater losses or recovering past investments.Agency theory provides a third explanation for escalation of commitments. When a manager posses private information on the state of the project, abandoning a potentially failing project would reveal this state and adversely affect the manager’s reputation while further commitment of resources protects the manager’s reputation. This paper extends previous work on the escalation of commitment by considering the effects of two additional variables that usually constrain managers’ decisions. These variables are managers’ potential liability for committing additional resources to a potentially failing project, and the level of credibility of a project’s prospective information that the manager obtains.A between-subject experimental design is used where the three research variables (managers’ responsibility, potential liability, and credibility of information about the prospects of a hypothetical project) are factorially crossed to obtain eight sets of experimental conditions (a 2x2x2 ANOVA design)The results indicate significant main effects of initial responsibility, potential liability, and information credibility. In addition, there were significant two-way interaction effects between initial responsibility and potential liability and information credibility.