Real Options and bias of commitment escalation

Escalation of commitment is a behavioural bias that occurs when a project manager continues a failing course of actions, while it is better to abandon the involved project. In such a case a manager who already invested a lot of effort and resources in a project, may not be able to resist the temptation to continue with their project, and may not understand the logic of sunk costs. This study investigated whether the use of the real option analysis as a capital budgeting analysis could mitigate this escalation of commitment, in comparison with the use of the traditional net present value method. An experiment was constructed for 64 university students with a finance background. The treatment group was told to use the real option valuation as capital budgeting analysis, while the control group was told to use the traditional net present value method. Both groups were challenged with the same case. The case was presented as an investment game in which the participants could earn an certain amount of money, depending on their performance. The case simulated an investment opportunity with two sequential time stages. The cash flows and the likelihood of success and failure were given and it was mentioned that the assets could be sold at any moment for a certain percentage of their value (implied option to abandon). In the first stage the participants had to decide whether to accept the project or not. If invested, they had to decide whether to continue or not in the second stage. In this second stage they were challenged with two different scenarios, both a bad and a good case scenario. The provided numbers in the bad case should evidently lead them to abandon of the project. Nevertheless, when one would continue in this bad case scenario, escalation of commitment is present. Significant evidence was obtained indicating that students using the net present value method were more prone to escalation of commitment than students using real option analysis. Hence, imbedding real options in a project valuation affects the behaviour of managers, reducing their tendency to escalate their commitment to a failing project. Furthermore, the occurrence of this escalation seemed to be significantly positively related with the degree of loss aversion of the participants. People with a high loss aversion might find it hard to accept losses when abandoning the project, and rather continue the failing project in order to avoid the threatening losses. Moreover, results did not indicate whether the mitigating effect of the real option valuation differs between men and women.