Behavioral discount rates for entrepreneurs: the effect of overconfidence

Abstract

Purpose – 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. Design/methodology/approach – 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. Findings – 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%. Research limitations/implications – Our expressions for the required rate of return depend on the assumption of the hyperbolic utility function. Other expressions will arise from other functions. Practical implications – While moderate overconfidence can help overcome the fear of failure, entrepreneurs suffering from excessive overconfidence will underestimate the total risk of a startup. Social implications – Excessive overconfidence could lead to bankruptcy. Originality/value – This is the first research that addresses overconfidence in relation to required rates of return.