Influence of Managers’ Subjective Judgments on Project Abandonment Decision Making

Abstract

Real option valuation with flexibility under uncertainty has been proposed as an alternative and advantageous complement to the traditional net present value (NPV) method for capital budgeting decisions, yet the problem with unrealistic expectations on precision has still not been solved. It appears clearly that a high level of precision in cash flow estimates can be misleading for the decision makers with sentiments. To the extent that precision surrounds a decision, we introduce a fuzzy process into an abandonment option approach, which is built on the use of fuzzy numbers, to investigate the effects of managerial optimism and pessimism when a manager considers whether or not to abandon capital budgeting decisions under imprecision and uncertainty. From the numerical analyses of the proposed model, we find that an optimistic manager tends to continue executing the project, while a pessimistic manager tends to give up the project and liquidate it as the value of the abandonment option is within the range of a fuzzy sentiments interval. In addition, if the project value is below the lower bound of the fuzzy sentiments interval, then it is better to exercise the abandonment option rather than to continue holding it, for both optimistic and pessimistic managers. Finally, this paper also examines why managers may still continue a project, even if its Tobin’s [Formula: see text] value is smaller than one.