The Bounded Rationality Bias in Managerial Valuation of Real Options: Theory and Evidence From it Projects

Abstract

Managers are often faced with the cognitively challenging task of assessing the value of prospective project opportunities in highly uncertain business and technological contexts. Recent developments in real options theory provide a powerful aid to help managers integrate information about not only the easily quantifiable benefits (such as those that can be computed in a traditional net present value analysis) but also the less easily quantifiable real options that may be embedded in a prospective project. Although real options theory normatively suggests that managers should associate such real options with project value, little field research has examined whether they suffer from systematic biases in doing so.

We draw on the notion of bounded rationality in managerial decision-making to explore this understudied phenomenon. Using data collected from managers in 88 firms, we show that managers exhibit what we label the bounded rationality bias in their assessments: They associate real options with value only when the project's easily quantifiable benefits are low, but fail to do so when they are high. The primary contribution of the study lies in showing how managers' valuation of real options are systematically biased by their bounded rationality. The study also contributes the first set of empirical measures for all key types of real options. The theoretical and normative implications of our findings are also discussed.

Keywords: real options, IT, software projects, bounded rationality