The Bounded Rationality Bias in Managerial Valuation of Real Options: Theory and Evidence from IT Projects*

Abstract

Although real options theory normatively suggests that managers should associate real options with project value, little field research has been conducted to test 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 a project's easily quantifiable benefits are low, but fail to do so when they are high. The study also contributes the first set of empirical measures for all six types of real options. The study contributes to managerial practice by identifying the conditions under which managers must be vigilant about inadvertently neglecting real options and by providing a simple approach for assessing real options in technology development projects.

Real Options and Escalation of Commitment: A Behavioral Analysis of Capital Investment Decisions

“…Tiwana et al (2006) experimentally tests the suggestion of Keil and Flatto (1999) that the presence of real options in a project can sometimes make escalation of commitment a rational phenomenon. The two studies posit that continuing commitment to a project that has suffered a setback may occur because the real options associated with the project make its future value positive, but that value is not apparent because those real options were not considered in placing an initial value on the project.…”

“…Those studies that exist in this area (Tiwana et al 2007;Yavas and Sirmans 2005;Miller and Shapira 2004;Howell and Jagle 1997;Busby and Pitts 1997) …”

When Experts Become Liabilities: Domain Experts on Boards and Organizational Failure

“…First, the higher the degree of decision uncertainty, the greater the likelihood that cognitive entrenchment will undermine the effectiveness of strategic decision making. As Dane (2010: 592) noted, entrenchment "may be especially costly during periods of change and uncertainty" because such periods demand greater flexibility from decision makers to address changing, unpredictable conditions (see also Tiwana, Wang, Keil, & Ahluwalia, 2007). In contrast, in routine situations with a relatively high degree of stability and predictability, entrenchment might be unproblematic, or even advantageous, as it can "produce functional and reliable responses to commonly encountered problems" (Dane, 2010: 592).…”

Unraveling equivocality in evaluation of information systems projects

“…In these studies, equivocality was a given independent variable and was manipulated in the experiments; thus, the causes of equivocal situations still remain a question mark. Furthermore, most studies concerning equivocality in IS/IT project mainly focused on the common use of capital budgeting techniques (Chulkov and Desai 2008;Keil and Flatto 1999;Taudes et al 2000;Tiwana et al 2006;Tiwana et al 2007). Evaluations using these techniques are argued of having a tendency to systematically underestimate the true value of the projects (Keil and Flatto 1999).…”

“…Several studies pointed the causes to the drawbacks of traditional capital budgeting techniques (Chulkov and Desai 2008;Keil and Flatto 1999;Taudes et al 2000;Tiwana et al 2006;Tiwana et al 2007). Keil and Robey (1999) indicated that escalations may be the result of equivocal situations formed by a lack of clarity about projects' success and failure criteria.…”