Open Universiteit

Please use this identifier to cite or link to this item:
Title: The influence of loss aversion on escalating commitment and dividend payout policies. Am I in too deep? Escalated commitment the why, the how and the aftermath!
Authors: Werf van der, A.M.A.
Keywords: loss aversion
escalating commitment (EOC)
dividend payout policies
Issue Date: 1-Dec-2013
Publisher: Open Universiteit Nederland
Abstract: Abstract: The influence of loss aversion on escalating commitment and dividend payout policies Stephany van der Werf An experiment is conducted to answer the following research question: How does loss aversion influence escalating commitment (entrapment) in regards to the free cashflow model and dividend payout policies? Escalating commitment causes managers to invest in projects that are less than optimal, which is against the expectation of the rational utility maximization model. However, an irrational manager may be unaware of behavioral bias. People must understand their own irrational mistakes and avoid these mistakes in order to avoid investing in projects that are less than optimal (Shefrin, 2000). Different psychological causes for escalating commitment include: managerial optimism, managerial overconfidence, self-justification and loss aversion. The focus in this research is on loss aversion, which forms part of the prospect theory. The goal of this research is to provide a scientific contribution to the existing prospect theory in regards to dividends and EOC. In the experiment 65% of the participants were found to behave relatively irrational and 35% were classified as relatively rational. Interestingly, not one participant behaved 100% rationally. There is a significant difference between rational and irrational participants in regards to their loss aversion and escalating commitment level. Indicating a higher level of loss aversion and escalating commitment for the irrational group. HO is rejected in regards to loss aversion. HO for loss aversion is stated as follows: subpopulation 1 & 3 and 2 & 4 are not influenced by loss aversion when making escalating investment decisions. This research indicates that there is a difference as to how the subpopulations handle loss aversion. Yet, there was no significant difference as to how they handle dividend decisions. Thus, for dividends the hypothesis was accepted, namely: there is no difference between subpopulation 1 & 3 and 2 & 4 as to how dividend payouts are assessed. Even though EOC occurred more often for the irrational group than the rational group the explanations given by the two different groups as to why EOC behavior occurred did not vary significantly. In other words, HO, which stated: “there is no difference between subpopulation 1 & 3 and 2 & 4 in regards to their explanation for EOC behavior in regards to investment behavior” is accepted. Thus, in regards to the problem statement theoretical proof has been found as loss aversion is dependent upon how a situation is framed and this is influenced by negative feedback. Negative feedback will weigh twice as powerful than positive feedback of the same volume and negative feedback increases loss aversion. The desire to recover sunk costs increases EOC and risk seeking behavior. Loss aversion related to irrational managers can lead to lower discount rates (lower IRR) to value cashflows, which will lead to a higher net present value, which leads to higher investments & higher debt & consequently lower dividend payouts as opposed to rational managers. The free cashflow model states that lower dividends will lead to higher cashflow, thus higher investments hopefully leading to increased capital gain to offset dividend payment. Yet, managers are reluctant to cut dividends even in financial distress to increase cashflow, because dividends are sticky and managers do not want to make dividend changes that need to be readjusted in the future. However, empirical proof in regards to the problem statement has only partially been found. No empirical proof has been found that loss aversion is the cause of EOC behavior. This can be due to the amount of items used to analyze EOC. By increasing the items relating to loss aversion a closer analysis as to how these are related to EOC can be done. However, a positive correlation has been found between EOC and dividend payout, which is against the expectancy of the free cashflow model, which predicts a negative relationship between EOC and dividend payouts. Managers are now finding themselves spending additional money on a failing research project and they spend an increasing amount of cashflow on dividends as well. However, the increased level of dividends could potentially offset the negative effects of failed investment projects in regards to keeping shareholders satisfied short-term.
Appears in Collections:MSc Management Science

Files in This Item:
File Description SizeFormat 
scriptie - Stephany van der Werf_definitief.pdf2.01 MBAdobe PDFView/Open

Items in DSpace are protected by copyright, with all rights reserved, unless otherwise indicated.