BA (Hons) in Business and Management

Contemporary Issues in Finance and Accounting

Behavioural Influences on Strategic Investment Decisions

BABM – part time, yr 3

Module Tutor: Dr. Tony Blackwood

Module: FN0369

STUDENT NAME XXX

Submitted: XXX

Word Limit: 3,000 (+/- 10%)

Word Count: Part One 1647 excluding contents page, tables, reference list and bibliography Part Two 1648 excluding contents page, tables, reference list and bibliography

Contents

Part One

Strategic Investment Decisions (SIDs)……………………………………………………………...01

Table 1: Harris, et al., (2009) SID Types…………………………………………………………………....01

Normative Approach to Decision Making…………………………………………………………...02

Investment Appraisal Techniques (IAT)…………………………………………………………….02

Table 2.1: Net Present Value (NPV)…………………………………………………………………………03

Table 2.2: Payback (PB)……………………………………………………………………………………...03

Table 2.3: Discounted Payback Period (DPB)……………………………………………………………...04

Table 2.4: Internal Rate of Return (IRR)…………………………………………………………………….04

Table 2.5: Accounting Rate of Return (ARR)………………………………………………………………..05

Descriptive approach to Decision Making ………………………………………………………….06

Psychological Influences on SIDs……………………………………………………………….07-08

Overconfidence ………………………………………………………………………………………..07

Status-Quo Trap………………………………………………………………………………………..08

Social Influence on SIDs…………………………………………………………………………...09-10

Groupthink …………………………………………………………………………………………..09-10

Table 3: Janis’ (no date) Symptoms of Groupthink (Kreitner and Kinicki, 2008) and its Consequences..10

Conclusion ………………………………………………………………………………………………11

Part Two

ORG XXX ……………………………….……………………………………….12

Decision Making Process at XXX……………………………………………………………………12

Psychological Factors Affecting XXX…………………………………….……………………….13-15

Overconfidence ………………………………………………………………………………………..13

Status-Quo Trap…………………………………………………………………………………….14-15

Social Factor Affecting XXX …………..…………………………………………………………..15-16

Groupthink …………………………………………………………………………………………..15-16

Conclusion ………………………………………………………………………………………………17

Reference ……………………………………………………………………………………………18-21

Bibliography……………………………………………………………………………………………...22

1

Part One

1. Strategic Investment Decisions (SIDs)

Bierman (2010) viewed SIDs as a large surplus of capital that organisations utilize in

undertaking a different course of action which affects the direction of the company and its

profits, either positively or negatively depending on the risks involved with the SID. Harris, et al.,

(2009) argued; depending on the organisation type, size and even culture SIDs (also referred to

as capital budgeting or even investment appraisal) differ from seven types as shown under table

1 where it is these seven types that affect profits along with its overall affect it has on an

organisation’s success or failure.

Table 1: Harris, et al., (2009) SID Types

1. New product development

2. New market development (new customers/clients)

3. New site or site development (operating facilities, e.g. new location, relocation and

expansion)

4. New technology or infrastructure (e.g. computer system development/ replacement)

5. Acquisition of business assets or companies

6. Compliance (new legislation, e.g. health and safety)

7. Others (e.g. decommissioning, downsizing and business process redesign)

2

In undertaking these SIDs lies in the hands of the organisation’s decision makers, where a poor

decision can not only damage the orgnisation but the career of the decision maker along with it

(Hammond, et al., 2006). These decision makers need to be aware of all relevant information

before making any decisions. Thus decision makers need to arrive at a solution whether they

want to pursue a systematic approach to decision making which is known as a normative

approach to decision making or an intuitive approach to decision making known as descriptive

approach to decision making (Boak, 2004, Koehler and Harvey, 2004).

1.1 Normative Approach to Decision Making

A normative model or approach to decision making involves the use of mathematical theories

and models used in the evaluation of judgment as stated by Koehler and Harvey (2004). This

could also be closely linked to Simon’s (1957) model of rationality concerning the ‘economic

man’ where an individual carries out rational decisions based on all relevant information coming

through investment appraisal techniques (Jones and Munro, 2005 and Burke and Wilks, 2006).

1.1.1 Investment Appraisal Techniques (IAT)

Burke and Wilks (2006) argued that IAT are only instruments that are used in finalizing on SIDs.

These techniques are explained in more detail under the following tables.

Table 2.1: Net Present Value (NPV)

3

Table 2.2: Payback (PB)

Table 2.3: Discounted Payback Period (DPB)

Brigham and Houston (2009, p.338) stated NPV as, ‘a method of ranking investment

proposals using the NPV, which is equal to the present value of the future net cash flow,

discounted on the cost of capital.’ In more simple terms it is difference between the current

inflows of cash and current outflows of cash.

The Rule for NPV

If NPV is positive then accept investment

If NPV is negative then reject investment

However the limitations facing an NPV technique is as Hawawini and Viallet (2011) argued

that it is far too complex for non financial managers to understand or even implement and

most importantly an NPV technique ignores change when opportunities and more

information arrives

Hall, et al., (2004) stated payback period as the time needed for a project to recoup its

investment and the main advantage with a PB period technique is that it is simple to use.

Example

A farmer buys farming equipment worth £30,000 and has estimated the following net cash

flow (after operating costs) for the next 5 years.

As shown above the payback period is only four years for the farmer as the net cash flow

from the first four years adds up to the invested £30,000 (4,000+7,000+7,000+12,000). Thus

year 5 would only yield profit from the investment.

The disadvantage here is that it ignores the profitability of the entire project or investment

since its main purpose is in figuring out the ‘speed of repayment’ (Hall, et al., 2004).

4

Table 2.4: Internal Rate of Return (IRR)

Table 2.5: Accounting Rate of Return (ARR)

Hawawini and Viallet (2011) argued DPB or economic payback period as being the number

of years it takes for the discounted cash flows of a project to finally match up to its original

investment and this technique has the advantage of allowing management to make the most

appropriate decision needed.

Formula DPB=

Year before full recovery + uncovered cost at start of the year / Discounted cash flow during the year

The disadvantage is that this technique ignore the cash values after reaching the DPB

period and thus is not a reliable measure of profitability (Clayman, et al., 2008)

NPV has the issue of not having an accurate discount rate and with the issues of interest

rates and inflation changing throughout the year, but IRR avoids these issues beforehand.

Therefore IRR is the rate at which an investment will return a net present value of zero and

the rule here is that if the IRR is more than the cost of capital then the investment should be

undertaken but reject an investment if the IRR is below the cost of capital (Hall, et al.,2004

and Burke and Wilks, 2006).

Formula

IRR = A+C / C-D (B – A)

A = Lower Discounting Rate

B = Higher Discounting Rate

C = NPV for Lower Discounting Rate

D = NPV for Higher Discounting Rate

5

ARR measures the return on investment as a percentage of the ‘capital cost of the

investment’ and is similar to ROI (Return on Investment) technique (Hall, et al., 2004 and

Burke and Wilks, 2006).

Formula

ARR (%) = Net Return (Profit) per annum / capital outlay (cost) ×100

The advantage of this technique is that as Ross, et al., (2008) stated was that is easy to

calculate and information needed for this technique is easily available.

Example

To find the ARR first businesses need to calculate the profit from the investment and in this

case total net cash flows - capital cost of investment

£95,000 – £80,000 = £15,000

The nest step involves calculating the profits per annum by dividing the profits by the

number of years it has run.

£15,000 / 5 years = £3,000

And finally the ARR can be calculated using its formula

ARR = 3,000 / 80,000 × 100

= 3.75%

The disadvantage here is that the time value of money is ignored and it only considers

accounting book values instead of cash flows and market values (Ross, et al., 2008).

6

However Harris, et al., (2009) saw that most decision makers are not solely guided on by the

findings of what IAT have to show and especially with a SID that involves uncertainty then

requires a more intuitive judgment or the use of the descriptive approach to decision making.

Intuitive judgment as Harris, et al., (2009) citing Kahneman and Tversky (1982) is the informal

and unstructured approach to judgment that is brought about without the use of any

mathematical facts and figures.

The importance of intuitive judgment is best explained by Hayashi (2001, p.60) where the author

argued, ‘recent research has uncovered…that our emotions and feelings might not only be

important in our intuitive ability to make good decisions but may actually be essential.’ Therefore

for successful and complex SID requires more than just quantitative data but also sound

judgment through an intuitive or descriptive approach.

1.2 Descriptive approach to Decision Making

By definition a descriptive approach to decision making is what Sousa and Kaymak (2002, p.17)

argued as being a cognitive process where the decision making process ‘searches for

explanations for the ways individuals or groups of individuals arrive at decisions so that methods

can be develop for influencing and guiding the decision process.’ This approach is close to

Simon’s (1957) bounded rationality of the ‘administrative man’ where decisions made are more

suitable for the current situation. Decision making is usually guided by past experience while

carrying out evaluations on his or her choice simultaneously until a satisfactory approach is

found (Harris, et al., 2009 and Singla, 2010).

The importance of a descriptive approach is as Hayashi (2001) stated was that as managers go

up in an organisation, decisions then start to become more complex which IAT cannot at times

solve, which then leads managers to rely on their ‘business instincts’. These so called business

instincts come from the experience decision makers get through their psychological and social

behavior. However it should be warned that these psychological and social behaviors may also

lead to bad decisions being made and the following are just a few of them that assist decision

makers in carrying out SIDs.

7

1.2.1 Psychological Influences on SIDs

1.2.1.1 Overconfidence

Vermeulen, P. and Curseu, P. (2008) citing Fischhoff et al., (1977) defined overconfidence as

the bias which results from decision makers when they are over optimistic in their arguments

where they are slow to take in the suggestions as their initial overconfidence is very strongly

held. This overconfidence behavior that decision makers display can be a result of them using

their heuristics for SIDs, which is the use of already experienced knowledge, values and beliefs

to solve a usually complex or uncertain problem (Harris, et al., 2009).

It is this ‘heuristics’ nature which is a managerial judgment tool that leads to overconfidence and

creates bad judgment that leads to costly mistakes which then leads to loss in opportunities or

increase in threat levels and eventually causes decision making failure (Hammond, et al.,2006

and Kiser, 2010). For this reason Harris, et al., (2009) citing Bazerman (2006) stated that the

one way to avoid the syndromes of overconfidence is by challenging the judgment of the

decision makers by using a systematic approach and to reach a ‘group based decision.’

It is also important to understand that overconfidence is a byproduct of excess optimism as

argued by Parikh (2009). This excess optimism can lead to as Lovallo and Kahneman (2003)

stated, decision makers to ‘exaggerate’ their skills which then leads decision makers to assume

that they are more than capable in handling any problems which in hindsight could be

dangerous at times.

However overconfidence or excess optimism will allow for companies being more aggressive

and leads to more ambitious and complex SIDs being pursued (Parikh, 2009). This form of

behavior as Lovallo and Kahneman (2003) argued creates more ‘enthusiasm’ at the expense of

realism but it nevertheless motivates employees when undertaken complex SIDs. Essig (2011)

viewed overconfidence being most appropriate in certain situations where the benefits of

success outweigh the cost of competition and when this situation arises overconfidence can

then even improve the chances of success.

But it only works appropriately if decision makers balance their overconfidence with realism

when large amounts of company funds are at stake, thus allowing for better judgment (Lovallo

and Kahneman, 2003).

8

1.2.1.2 Status-Quo Trap

The status quo trap or status quo bias is what Harris, et al., (2009) identified as essentially to

‘do nothing’ when it comes to decision analysis. This could be attributed to the fact of decision

makers’ strong bias towards not changing the current form of the business or how it may be run

in anyway (Beatty and Scott, 2004).

Hammond, et al., (2006) in their research discovered that decision makers will stick to their

status quo when they are faced with two conflicting objectives as selecting between two or even

more alternatives requires more effort which the decision makers do not want to endure. The

reason for undertaking such a bias approach is because of the managerial judgment tool of

‘framing,’ which is what Harris et al., (2009) argued as how managers perceive the many

different objectives that are laid out in front of them which is dependent on how the propositions

are ‘presented or framed’ due to personal choices that may then lead to a bias in the ‘human

processing of information.’

The reason that why decision makers at times without knowing fall in favor of the status quo trap

is as Hammond, et al., (2006, 122) stated, ‘In business, where sins of commission (doing

something) tend to be punished much more severely than sins of omission (doing nothing).’

Thus the status quo trap behavior allows decision makers to protect their egos from any

‘psychological risks’ while conforming to the tried and tested methods by avoiding new SIDs

(Mascarenhas, 2011).

However in some ways the status-quo can be used as a lesson to decision makers in reminding

them of sticking to the current routine as earlier attempts to move away from the status-quo was

disastrous (Bakker and Helmink 2000). Therefore in this regard the status-quo trap would be

justifiable if past unsuccessful initiatives have shown that moving away from the status-quo

proved to be disastrous.

But as Hammond, et al., (2006) argued decision makers need to be aware that the current

situation could act as a barrier to the overall goals. Decision makers should avoid the status quo

trap when making SIDs, especially when faced with a volatile market that requires outside the

box form of ideas to be implemented.

9

1.2.3 Social Influence on SIDs

1.2.3.1 Groupthink

Levi (2011) defined groupthink as the desire by the part of the decision makers in a group to

maintain agreement through harmony and as a result creates bad decisions. This form of

decision making and its outcomes are seriously flawed as pressure within the group for

agreement and harmony has the ill effect of making group members not to raise any issues that

may lead to arguments within the group (Jones, 2009).

10

Table 3: Janis’ (no date) Symptoms of Groupthink (Kreitner and Kinicki, 2008) and its Consequences

.

1. Invulnerability – an illusion that breeds excessive optimism and risk taking.

2. Inherent morality – a belief that encourages the group to ignore ethical implications.

3. Rationalization – protects pet assumptions

4. Stereotyped views of opposition – cause group to underestimate opponents.

5. Self-censorship – stifles critical debate.

6. Illusion of unanimity – silence interpreted to mean consent.

7. Peer pressure – loyalty of dissenters is questioned.

8. Mindguards – self protectors against adverse information

Groupthink Consequences

The consequences of a groupthink decision making approach is that decision makers neglect to

explore all possible alternatives when arriving at a final decision thereby resulting in poor

decisions being formed along with no though given to a contingency plan. Decision makers even

fail to re-examine their decisions when new information comes to light as decision makers only

show interests to findings that support their choices while ignoring findings that do not support

their decisions (Hitt, et al., 2005).

But most importantly as Hitt, et al., (2005) stated decision makers fail to consider the view points

of internal or external experts and as Lovallo and Kahneman (2003) wrote having either inside

and outside views would allow for all alternatives to be viewed clearly and give more reliable

findings for decision, which as Myer (2010) stated as encouraging critical evaluation, while not

taking any sides while being impartial.

However this does not imply that group decision making is ineffective as groupthink makes it out

to be, it is quite the opposite. As McFarland (2007) notes, for there to be any effective solutions

to decision making, there needs firstly to be group diversity thus including a decision making

team from all levels within the company that comes about through decentralization. Group

members need to be allowed to act independently and not be pressured into decisions. And

finally the ideas and inputs should be gathered from this diverse group in a way that does not

‘undermine diversity or independence’.

11

1.3 Conclusion

The psychological and social behaviors affecting SIDs are is in some ways destructive to SIDs.

However intuitive judgment is appropriate when faced with a volatile market and a complex SID

that IAT cannot provide answers for. These ambitious SIDs arise from intuitive judgment and

creates employee motivation and enthusiasm (Lovallo and Kahneman, 2003).

But it should also be remembered that not everyone has the intuitive judgment to carry out

complex decision as it comes through experience, knowledge and most importantly self

awareness. All the three qualities are what decision makers should poses when undertaking

SIDs using their intuitive judgment (Hayashi, 2001 and Harris, et al.,2009).

12

Part Two

2. ORG A

Established in 1979 XXXXX

2.1 Decision Making Process at XXX

The decision making process for XXXB is handled by a group that consist of senior managers

from the organisation, along with the CEO who has to put forth a SID that he sees fit in front of

the board members for approval. Strategic decision making is highly centralized to these group

members.

Along with its highly centralized decision making process, XXX most often heavily relies on its

normative approach in decision making. That being said certain decisions are still affected by

the above mentioned psychological and social factors and thus will be applied here on how it

would affect XXXs decision making team in its SIDs tasks and its overall performance.

2.2 Psychological Factors Affecting XXX in its SIDs

2.2.1 Overconfidence

The Sri Lankan economy currently is on an all time high with the local economy enjoying healthy

growth rates that have caused a huge surplus in demand from the financial sector thus fueling

overconfidence (LBO, 2011 and Central Bank of Sri Lanka, 2011). This surplus in demand that

creates overconfidence might lead XXX becoming complacent if they do not properly plan

ahead as the local economy was never known to be stable (LBO, 2010).

As overconfidence is due to what Harris, et al., (2009) calls the ‘heuristics’ nature, the decision

making team behind XXX’s strategic investment will already be aware of the history of the local

economic as well as political environment in undertaking SIDs that would harm profits and

13

especially the reputation of XXX. Therefore the key here is for decision makers to consider an

inside and outside view when forming decisions (Lovallo and Kahneman, 2003).

Overconfidence as mentioned in part one most of the time leads to bad decisions being made.

History has already established that overconfidence by decision makers in organisations was

the root of cause of the recent global economic meltdown that saw the foreclosure of many

organisations including XXX (Bottelier,2011). However with so many of the orgasnisations on

the island undertaking expansive SIDs, XXX would also benefit from such expansive and much

complex investment measures that comes through overconfidence shown in getting the projects

running.

Thus overconfidence assists in gathering support for new and un-ventured strategies. Once the

team conveys their confidence to the board, senior managers can then spread their confidence

about the project to the entire organisation thus creating enthusiasm and motivation to the new

proposed project within the entire organisation (Lovallo and Kahneman, 2003). This

overconfidence might also be felt externally as investors feel secure when decision makers

show confidence in their investment strategies.

When it comes to selling a product such as loans there needs to be confidence in the individual

that obtain the loans. Therefore intuitive judgment through overconfidence plays an important

role in making the decision for XXX. However decision makers need to sell their enthusiasm to

all interested stakeholders for it to bare any fruits.

2.2.2 Status-Quo Trap

When considering the current economic climate that XXX is facing and the current rivalry faced,

XXX needs to implement new strategies that allow them to benefit from the current economic

climate and mitigate the threat of rivalry it faces. However if the decision makers do not take

such a proactive approach to decision making XXX will lose out much on opportunities, which

could be considered as a financial sin on the part of the decision makers at XXX.

The status-quo trap, if adhered to will lead XXX in the same path that it was running all along.

Decisions will then be made on the tried and tested methods of the organisation, thus avoiding

any new strategy and forgoing any new opportunities that arise.

14

For example under the government regime from 1979, XXXX. It took nearly three decades for

the status quo to be challenged.

The reason why it took nearly three decades for the status-quo to be challenged was because

the author believes was XXX’s decision to follow a centralized decision making culture. If

management had questioned the status quo sooner XXX might have experienced much more

opportunities.

With the centralized decision making system prevalent at XXX allowing for ideas of the decision

making team to take center stage, new ideas through suggestions from operational staff that

might have valuable information on the market and even customer insights are neglected. The

status-quo trap thus have blocked out suggestions or alternative for SIDs from employees other

than the decision making group which could also be attributed not only to the centralized nature

of XXX but also the working culture.

Another example of the status-quo trap currently affecting XXX is their inability to think more

descriptively where in undertaking any investment decision. The decision makers only take into

consideration the normative approach where mathematical formulas are heavily used in

evaluating an investment decision. But normative approach only limits to mathematical formulas

thus economic changes are disregarded such as lifestyle patterns of wants that are changing,

and if the management sticks to this method, opportunities will not be grasped as intuitive

judgments through experience and knowledge can identify certain trends that facts and figure

cannot.

Also biding by the status quo could affect people to perform to their maximum potential. As

customers’ wants are different, the products need to be assigned differently for these different

customers to ensure maximum customer satisfaction is maintained. But XXX has little variations

to the norms laid, therefore the status quo trap will allow for no differentiation of its customer

service, which in marketing is crucial as all consumers have different wants and needs (Hall, et

al., 2004).In the case of XXX differentiation might be neglected because decision makers

‘frame’ that all customers have the same needs and wants (Harris et al., 2009).

All this inactive behavior at XXX is attributed to decision makers protecting against what

Mascarenhas, (2011) identified as ‘psychological risk’ which comes through taking minimum risk

as decision makers fear moving away from the current status-quo of XXX.

15

With the centralization decision making process fueling the status-quo trap, XXX management

needs to welcome all possible options in SIDs and have an open mindset (Hammond, et al.,

2006).

2.3 Social Factor Affecting XXX in its SIDs

2.3.1 Groupthink

As mentioned above, the decision making team at XXX consist of active directors and senior

managers. This group has been together for nearly a decade now. It could then be said that

this group members may have formed some sort of attachment to each other thus this is where

the problem of groupthink begins.

As this bond is formed by the members of the team this can then be seen as a sign of threat in

implementing critically planned SIDs as members search for what Levi (2011) argued as being

harmony at the expense of feasible SIDs. Thus when groupthink syndrome kicks in decisions

made may have dire consequences if they are not critically reviewed by the entire team.

As Kreitner and Kinicki (2008) stated that in any decision making group there is one individual

who is more dominant in the team and for XXX that individual happens to be the CEO. As the

CEO only has the power to pick which strategy or strategies to put forth for approval, the

decision making team then has to offer a solution that suits the CEO’s criteria. Therefore this

process creates what McFarland (2007) described as ‘undermining diversity or independence’.

McFarland (2007) even argued that for precise decision making from a group there needs to be

diversity and for XXX that diversity should go beyond the current crop of senior managers and

directors in the team. Mid-level level managers and operational level staffs need to be consulted

along with external consultation from experts as these groups all have much valuable

information in molding strategies. In ensuring the feasibility of a strategy and in gathering a

broader understanding of the situation these groups also need to be consulted. If these groups

are not consulted, decision making will then be restricted from thinking outside the box.

Therefore if XXX wants to move away from a groupthink syndrome then it needs to movefrom

its centralized decision making culture to a de-centralized decision making culture. Thus when

gathering the view points of the many employees at XXX creates motivation as these

16

individuals feel involved in the company strategy planning (Hall, et al., 2004). When this

happens better decisions are formed and Nohria, et al., (2008) argued causes performance

improvements through motivation to take place.

2.4 Conclusion

All three elements were influenced by either internal or external factor affecting XXX. For

example overconfidence can be blamed on the current favorable economic climate that fuels it,

thus leading to more ambitious but unpredictable SIDs to be undertaken. For status-quo trap

and groupthink can be blamed on the internal cause of the current decision making culture and

the gate keeper to decision making that is the CEO.

If XXX wants to rely on its intuitive judgment they need a realistic approach in decision making,

by create a de-centralized decision making culture, thus making these psychological and social

behaviors more reliable.

17

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