Investment Decisions & Project Evaluation Biases
Corporate Investment Process
Stages:
- Idea generation
- Preliminary screening
- Detailed analysis (NPV, IRR)
- Capital budgeting approval
- Implementation
- Post-audit
Traditional Assumption: Rational NPV maximization at each stage.
Reality: Behavioral biases systematically distort every stage.
Biases in Project Selection
Overoptimism in Cash Flow Projections
The Problem: Revenue projections consistently exceed realized outcomes by 20-50%.
Behavioral Drivers:
- Overconfidence: "We're better than competitors"
- Planning fallacy: Underestimate time/cost, overestimate benefits
- Anchoring: On best-case scenarios
- Confirmation bias: Seek supporting data, ignore risks
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Reference Class Forecasting Failure
Error: Evaluating projects in isolation rather than comparing to similar past projects (reference class).
Example: New pharma R&D project
- Isolated view: "This drug has 60% chance of FDA approval"
- Reference class view: "Historical FDA approval rate for drugs in this class is 8%"
Why it matters: Anchoring on specific project details (inside view) vs statistical base rates (outside view).
Kahneman's Advice: Always check: "What happened to similar projects?" Use that base rate as starting point, then adjust for specifics.
Sunk Cost Fallacy in Project Continuation
Definition: Continuing projects because of past investments, even when future NPV is negative.
Example:
- Spent ₹100 crore on project
- Need ₹50 crore more to complete
- Expected future value: ₹120 crore
- Rational decision: NPV = ₹120cr - ₹50cr = ₹70cr positive → Continue
- Biased decision: "We've already invested ₹100cr, can't waste it!" → Continue even if future NPV negative
Why it happens:
- Loss aversion: Abandoning project feels like realizing loss
- Escalation of commitment: "Just a bit more will make it work"
- Self-justification: Don't want to admit initial decision was wrong
Indian Example: Kingfisher Airlines continued operating 2010-2012 despite mounting losses, pouring in funds to "recover" past investments, eventually losing everything. Sunk cost fallacy prevented timely exit.
Empire Building & Free Cash Flow
Jensen's Free Cash Flow Hypothesis: Managers with excess cash invest in value-destroying projects rather than returning to shareholders.
Behavioral Amplification:
- Overpayment in acquisitions: Use cash for empire-building M&A
- Pet projects: Fund low-NPV projects manager is passionate about
- Avoiding difficult decisions: Easier to invest than downsize/return cash
Evidence: Firms with high free cash flow AND weak governance have ~30% lower ROI on new investments.
Indian Context: Several Indian conglomerates (Reliance ADAG, Sahara) diversified into unrelated businesses during cash-rich periods, destroying significant value. Core competency abandoned for empire expansion.
Capital Budgeting Process Biases
Hurdle Rate Manipulation
Managers gaming the system:
- Strategic projects: Lower hurdle rate to approve pet projects
- Unfavored projects: Raise hurdle rate to reject
- Result: Capital allocation driven by politics, not economics
Earnings Management Distortion
Problem: Managers focused on quarterly earnings manipulate investment timing.
Example: Delay capex in Q4 to meet earnings target, even if NPV-positive.
Long-term cost: Underinvestment, deteriorating competitive position.
Prob
ability Weighting Errors
Overweight small probabilities: "Home run" projects with 1% chance of 100x return get funded over steady 20% IRR projects.
Underweight moderate probabilities: Steady projects with 70% success chance undervalued vs. "exciting" long-shot bets.
Result: Portfolio tilted toward lottery-like projects, underinvesting in boring but profitable opportunities.
Debiasing Techniques
Pre-Mortem Analysis
Process: Before approving project, imagine it's 3 years later and the project failed spectacularly. Team writes "failure report."
Benefits:
- Surfaces risks that optimistic planning missed
- Gives permission to voice doubts
- Reduces overconfidence
Example: Amazon uses pre-mortems for major initiatives. Jeff Bezos: "This exercise is designed to call out risks in a productive way."
Outside View / Reference Class Forecasting
Process:
- Identify class of similar projects (e.g., "retail store expansions in Tier-2 Indian cities")
- Calculate historical outcomes (e.g., "60% achieved payback within 3 years")
- Use that base rate as anchor, adjust for project-specific factors
Evidence: Reduces forecasting error by 30-40% for major infrastructure projects.
Independent Review Boards
Structure:
- Separate team (no project involvement) reviews business case
- Devil's advocate role: Explicitly argues against approval
- External consultants challenge assumptions
Key: Independence prevents groupthink and confirmation bias.
Competitive Bidding for Internal Capital
Process: Business units compete for limited capital budget
Benefits:
- Forces realistic projections (overpromise → career damage when missed)
- Market discipline on internal allocations
- Reduces empire building (can't fund everything)
Post-Investment Audits
Process: 3 years post-investment, compare actual vs. projected
Benefits:
- Creates accountability
- Reveals systematic optimism patterns
- Improves future forecasts (learning)
Critical: Must be non-punitive for honest mistakes, only punish dishonest projections.
Key Takeaways
- Overoptimism endemic: Cash flow projections exceed reality by 20-50% due to overconfidence, planning fallacy
- Sunk cost fallacy: Continuing negative-NPV projects to "recover" past investments destroys value
- Empire building: Free cash flow + weak governance → 30% lower ROI on new investments
- Reference class neglect: Ignoring base rates of similar projects causes forecasting errors
- Indian examples: Delhi Metro overruns, Kingfisher sunk costs, conglomerate diversification
- Debiasing: Pre-mortems, outside view, independent review, competitive budgeting, post-audits
- Process matters: Structure decision process to counter biases at each stage
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