Impacts of Internal Financing on Investment Decisions by Managers with Cognition Biases

Abstract

This paper extends the standard model of real option by allowing managerial biases originating from the cognition about the economic states in the future to examine the impacts of internal liq-uid funds on the firm's investment decisions. The model indicates that the interactions between the cognition biases and firm's volatility determine the extent to which the manager overesti-mates the growth rate, hence subjectively overvalues the firm's value and distorts the investment decisions. The managerial cognition biases enhance the sensitivity of corporate investment to cash flow and increase the convexity of the investment decisions against the firm's volatility. Re-lying on the amount of internal liquidity, the manager with cognition biases can both delay and expedite investing.