Retrievability bias in explaining the hurdle rate premium puzzle

Abstract

Purpose Making rational and undistorted corporate investment decisions is critically important to organisations. “Scientific” investment appraisal can play a central role, particularly setting the hurdle rate. Empirical research reveals that actual rates generally exceed organisations’ cost of capital – the so-called hurdle rate premium (HRP) puzzle. Allowing for bounded rationality of corporate decision-makers, the purpose of this paper is to mobilise the retrievability cognitive bias as one explanation of this paradox. Design/methodology/approach A systematic structuring and investigation of the legacy of eight scenarios, representing “correct” and “incorrect” decisions on “good” and “bad” proposals, is used to explain the inconsistency between normative capital investment theory and actual practice. Findings Decision makers’ cognitive processes based on informal perceptions, strengthened by the scope of formal post-audit routines, provide a plausible explanation why investment decision makers tend to systematically set hurdle rates too high. Research limitations/implications The findings have still to be explored in more depth by fieldwork and experimental research. Practical implications The policy implications of this study are that corporate success could be enhanced by making executives aware of the HRP phenomenon and of its behavioural causes; also by including significant rejected investment proposals in the post-audit programme and communicating the opportunity cost of “false negative” decisions on proposals not adopted. Originality/value The paper provides a new explanation for a recognised phenomenon: Allowing for bounded rationality of corporate decision-makers, the paper applies research on a cognitive bias to the setting of the hurdle rate in investment appraisal.