The Effect of Debt Financing on Capital Investment Decisions Based on Mental Accounting Theory

The weaknesses of economic theories in explaining individual judgment and decision making (JDM) has led to the development of psychological theories. Our paper examines the effect of past debt financing (for purchasing an asset) on managers’ decisions about keeping or replacing an asset. We also study the possibility of costly decision errors in the case of using mental accounting by managers.

We have used an experimental method applying two 2×2 between subjects factorial designs. Our experiment manipulates debt magnitude and debt security. Dependent variables for two factorial designs, are participants’ capital investment decision and past benefit perception. To explore the role of “past benefit perception" variable, as a mediator, between the unpaid principal and the capital investment decision, the regression patterns of Baron and Kenny (1986) have been used. Participants consist of 80 students and professionals assigned to one of four groups through random assignment.

Our results suggest that greater unpaid principal causes managers to be more reluctant to part with the asset. As the unpaid principal decreases, individuals’ willingness to replace the asset increases. We also find that participants' perceptions about the past benefits realized from the asset mediate the relation between the unpaid principal balance and participants' investment decision. So, individuals’ reluctance to dispose the asset in the case of high level of unpaid principal is related to the past benefits perceptions. In addition, our findings show that the level of security has no effect on manages’ capital investment decision. From a cognitive perspective, the onerous thought of a large lump sum principal payment (when the debt is secured) or an ongoing stream of future debt service payments (when the debt is unsecured) without any matching benefits appears to overwhelm the economic benefits of replacing the machine.

Our study shows that a psychological factor may cause managers to forego investments that they should invest according to the capital budgeting techniques. This cognitive bias arised from the formation of mental accounts reduces JDM quality. Being aware of such cognitive biases contributed to the accounting literature through providing valuable information for capital budgeting studies. It is highly recommended that affiliated Finance, Business and Accounting faculties allocate specific modules in mental accounting and related cognitive biases for post graduate students. In terms of future research directions, it is recommended to study the effect of different debasing techniques such as instruction on the JDM quality in future research