Behavioral discount rates for entrepreneurs: the effect of overconfidence

Abstract

In this study, we aim to show the effect of entrepreneurs’ overconfidence on their required rates of return. Accordingly, we show the implication of two levels of overconfidence: moderate and excessive.We use a hyperbolic absolute risk aversion utility function with a payoff function affected by an ego component to derive different expressions of required rates of return for non-diversified entrepreneurs.Using simulations of these expressions, we show that a confident entrepreneur will require an annual average required return of 76.49%, an entrepreneur with moderate overconfidence will require an average return of 20.80% and an entrepreneur with excessive overconfidence will require an average return of 1.77%.Our expressions for the required rate of return depend on the assumption of the hyperbolic utility function. Other expressions will arise from other functions.While moderate overconfidence can help overcome the fear of failure, entrepreneurs suffering from excessive overconfidence will underestimate the total risk of a startup.Excessive overconfidence could lead to bankruptcy.This is the first research that addresses overconfidence in relation to required rates of return.