The Role of Mental Accounting in Capital Budgeting Decisions

Current paper examines the effect of retrospective source of finance on the capital budgeting decisions and investigates the possibility of costly decision errors in the case of using mental accounting by managers. This experimental study has utilized a 2*2 between subjects factorial design. Independent variables that are manipulated in this paper are retrospective source of finance and prospective source of finance. The sample consists of 160 participants including executive experts and academic persons assigned to one of the four groups through random assignment. Results show that managers are less likely to part with a debt financed asset in comparison with an identical equity financed asset. The reason behind above reluctance is related to the managers’ perceptions about the asset’s past benefits. This study shows that a psychological factor may cause managers to forego investments that they should invest according to the capital budgeting techniques. In this way, the results can contribute to the accounting literature through providing valuable information for capital budgeting studies