Question

What are some of the ways in which managers might think they are making rational empirical decisions on capital investments when in fact they are being swayed by more subjective perceptions and unfounded assumptions? How does human psychology and the dynamics of human judgment impact such financial decisions? Do some internet research to support your conclusions.

Answer 1

The primary reason that businesses exist is to bring maximization of wealth to shareholders. In their pursuit of richs, peoplecan organize their businesses in several ways. The decisions regarding capital investments is really a two-prolonged question:

1. What is the potential income?

2. How risky is the investment?

A basic tenet of finance dictates that the return should be commensurate with risk. It is the job of a financial manager to help the management team evaluate an investment, rank them, and suggest the best choices of the lot.

When we talk about decisions on capital investments, the very concept of goal congruence comes into picture. Goal congruence implies that any financial manager should make a capital investment decision keeping in mind the benefit for the organization rather than for himself. If a financial manager evaluates an investment which will fetch him/her more incentives, but at the same time, will be detrimental for the firm, the investment should not be supported.

Second, human psychology runs behind profit making first and then assessment of risk. When those investments are favoured, those capital decisions may turn against the objective of shareholder's wealth maximization. As a result, the prospective stream of investments would have a riskier earnings per share if these projects were undertaken. The financial risk also contributes to the overall risk to the investor. Two companies may have the same anticipated EPS, but if the earnings of one is susceptible to more risk than the earnings of the other, the market price per share of that particular stock may well be less.