Managers’ Incorporation of the Value of Real Options into Their Long-Term Investment Decisions: An Experimental Investigation

Abstract

While academic and practitioner literature has advocated the use of real options in firms’ long-term investment appraisal processes, few studies have examined the extent to which real options are incorporated into decisions when they are made available. We experimentally examine supervising managers’ decisions of how much funding to provide to subordinates’ long-term investment project proposals. We predict and find that supervising managers rely less on the value of real options than the value of a project’s planned implementation path when making these decisions, and that providing a financial summary aggregating the planned path and real options components of value rather than displaying them separately increases reliance on the real options component. We provide evidence that the financial summary affects decisions through perceptions of the relative accuracy of the planned path and real options components of value. Further, we explore how the proportion of total project value from real options affects managers’ reliance on non-cash-flow information.

Keywords: Long-term Investments, Real Options, Aggregation, Judgment and Decision-Making

JEL Classification: D89, G31, L29, M49