| Summary: | A growing body of literature in investment appraisal has focused on bounded rationality of managerial decision-makers. It mostly addresses the actual investment decision stage, i.e. project approval. The investment decision is usually supported by a financial appraisal of the investment projects under consideration. Bounded rationality of the decision-makers determining the parameters of a financial appraisal have, however, attracted little attention. In the field of judgement and decision-making, decision-makers have been found to rely on a variety of effort-reducing strategies, i.e. heuristics, when making a judgement. This work addresses heuristic reasoning in the narrow field of setting the parameters required for a discounted cash flow analysis. Both dimensions, the projection of cash flows and the setting of a risk-adjusted hurdle rate, have been found to incorporate a high degree of subjective judgement. Moreover, given the complex and uncertain environment of companies and of the investment context in particular, optimal parameters may be difficult to determine. This work identifies heuristics that actors involved in this narrow stage of investment appraisal intuitively apply. It proceeds in two steps. First, and based on a conceptual framework, a qualitative study of practitioners detects and classifies indications of judgement in the projection of cash flows and in the setting of a hurdle rate. The findings that are indicative of heuristics translate into hypotheses for a second, quantitative study: Five experiments on practitioner-proxies are used to examine heuristic reasoning in the narrow contexts of investment appraisal. We find evidence that the affect heuristic and the anchoring effect substitute the more difficult judgement of a project’s risk that is manifested in a project-specific hurdle rate. Our hypothesis that the availability heuristic may also be involved in judging project risk cannot be confirmed; it is not found to contribute to an explanation of the paradox of setting hurdle rates higher than appropriate. As regards the projection of cash flows, application of the representativeness heuristic was not found to be applicable – despite strong indications in the qualitative study. Strong evidence is found in favour of the anchoring effect in making cash flow estimates – with finance or accounting experts being particularly prone to rely on arbitrary anchors. A sixth experiment investigates the practice of adjusting hurdle rates to mitigate the risk of overconfident cash flow projections. This work therefore contributes to an enhanced understanding of the role of judgement and the underlying judgemental processes in the two dimensions of investment appraisal. It highlights boundedly rational behaviour of the actors involved in the vital process of investment decision-making which has not been systematically addressed elsewhere. It can contribute to an improved understanding of organisational behaviour and ultimately to corporate success.
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