PROSPECT THEORY AND CAPITAL INVESTMENT DECISIONS: \ud An EMPIRICAL EVIDENCE FROM PAKISTAN

Expected Utility Theory had been considered as a standard normative theory which described the \ud choices of individuals in risky situation very well for a long time, but later on violation of its \ud axioms in real situation was commonly found which created a need for the development of \ud another theory which could accommodate the behavior of individuals very well. Ultimately \ud Prospect theory was proposed by Kahneman and Tversky (1979) as an alternative of Expected \ud Utility Theory in order to provide remedy against descriptive failure of this theory. Later on, an \ud advanced version of this theory was also presented by them named as Cumulative Prospect \ud Theory (1992). This theory incorporated the behavioral aspects of individuals while making \ud decisions in an uncertain environment. Application of Prospect Theory was very commonly \ud found in various areas of economics and finance, but its application in the field of capital \ud investment decisions of companies which is an area of corporate finance is yet very rare. \ud Implications of this theory state that investors are risk averse in their behavior when they make \ud their decisions in the domain of gain and are risk seeking in their attitude when they make their \ud decisions in the domain of loss. This gain or loss is calculated relative to a reference point. This \ud phenomenon implicates that risk and return are negatively correlated. Moreover, risk averse \ud attitude in gain is equivalent to risk seeking attitude of same magnitude in the loss domain. This \ud phenomenon is known as Reflection Effect. Likewise, they also own loss averse attitude i.e., \ud sensitivity of loss is felt by them more than the sensitivity of gain. Such a behavior of investor \ud which is based on parameters of Prospect Theory has been characterized as an irrational \ud behavior. This study has been conducted to examine whether or not this irrational behavior \ud prevail in capital investment decisions of companies as well. For this purpose, two phase value \ud function of Prospect Theory has been used as an empirical model of this study. First phase \ud applies to gain situation and the second phase applies to loss situation. Change in capital \ud investment ratio has been used as a dependent variable and financial performance of companies \ud i.e., ROA and then ROE has been used as independent variable. Firstly, impact of ROA on \ud change in capital investment has been checked and later on impact of ROE on the same \ud dependent variable has been checked. Once, existence of Prospect Theory behavior was found, \ud we applied two control variables i.e., financial constraints of firms and corporate governance \ud mechanism in order to observe whether this behavior is abated by these variables. Financial \ud constraints are measured by Debt Equity ratio (DER), Operating Cash Flow to Sales (OCF), Free \ud Cash Flow to Sales (FCF), Dividend Payout ratio (DPO) and Fixed Assets ratio (FAR). While \ud corporate governance has been measured through Board Size (BSI), Board Independence (IND), \ud CEO-Chairman Duality (DUA), Audit Committee Independence (ACI), Shareholders Activism \ud (ACT), Institutional Ownership (IO) and Ownership Concentration (CON). Annual data \ud regarding KSE listed companies was used in this study for the period of 1996-2011. This data \ud was obtained from Balance Sheet Analysis published by SBP, KSE website and Annual Reports \ud of companies. Regression analysis and factor analysis technique was used in this study. After \ud analyzing secondary data, application of Prospect Theory behavior in Pakistan was also checked \ud through primary data with the help of a survey questionnaire which was distributed among the \ud same 139 companies which were part of the secondary data analysis. Results have indicated that \ud application of Prospect Theory is not at the same level all the time due to variations in human \ud attitude over time. Existence of Prospect Theory behavior among companies is found in \ud situation of gain i.e., they are risk averse in gain. These results are consistent on both primary \ud and secondary data. Indications regarding their risk seeking behavior in loss are also found. \ud Existence of reflection effect is also found. Companies are also found loss averse. Joint role of \ud financial constraints of companies and corporate governance mechanism is important in \ud controlling their risk averse and risk seeking behavior. Moreover, evidence is found regarding \ud existence of negative relationship between risk and return of companies