8 c.behavioral Corporate Finance

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How to Make Better Decisions?

Lessons Learned from

Behavioral CorporateFinance


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Introduction

Corporate Finance describes the interaction between

managers and investors and its impacts on firm value.

Traditional theory supposes that both groups act rationally.

If this was true, managers could assume efficient financialmarkets. This means that stocks and bonds would befairly

pricedin every single moment.

In reality, however, rational behavior cannot be assumed foreither managers or investors.

Instead, Behavioral Corporate Finance : Several psychological

biases influence decision making of both groups.


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Two types of research studies:

The first approach:

Irrational behavior of managers in the context of efficient

financial markets.

The second approach:

Investors are systematically irrational but managers are

rational and well-informed.


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Many empirical studies discover irrationalmanagerial behavior that is systematic.

overconfident and excessively optimistic (Ben-David, Graham & Harvey, 2010).

Anchoring, mental accounting and boundedrationality (Baker, Ruback & Wurgler, 2004;

Gervais, 2010).


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Definition

Overconfidence Individuals believe that they are better than they really are.

Excessive optimism The frequency of favorable outcomes is overestimated.

Anchoring

People anchor on an unimportant number and adjust

insufficiently.

Mental accounting Deciding based on different mental accounts.

Bounded rationality

Decisions are not rational because individuals have

incomplete information.

Table 1. Definition of biases (see also Shefrin, 2007)


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The irrational investor approach assumes that managers

possess aninformational advantageover investors.


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Seyhun (1992) confirms that managers arewell-informed:

He shows that they outperform themarket with legal insider trading (Baker &Wurgler, 2012).

Muelbroek (1992) studies illegal insidertradingand also finds that managers earnhigher returns than the market.


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Irrational Managers and Efficient

Markets

Considering managerial decisions to the disadvantage of

shareholders, the literature distinguishes between

intentional and

unintentional(psychological reasons)

value reducing decisions.


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Psychological Barriers to

Arms Length Contracting Jensen and Meckling model assumes that the

independent non-executive directors deal with thesenior management team atarmslength.

Examining the explosion of executivecompensation, often in response to mediocreperformance, Bebchuk and Fried (2004) haveconcluded this arms length contracting model

of corporate governance is largely fictional.

Reasons:


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Interlocking directorships CEO of AAA Co. is on the board

of BBB Co. and the CEO of BBB Co. is on the board of AAACo.Loyalty Often the CEO nominates or has a veto over

potential new independent directors. So, avoiding anythingthat goes against your patron is highly probable.

CEOs are rather forceful people. So, confronting them could

be bruising andretaliationis expected.Most of us like to think that we do a pretty good job and shun

evidence that suggests otherwise. cognitive dissonance .Many non-executive directors are retired successful CEOs ofthe company itself or companies in the same sector. So, thebig pay-packets and severance terms they received will bequestioned if they raise the same questions for the companiesin whose board they are now.


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Group Psychology on the

Board, Building Consensus

and its Dissimulation

The centrality of group decision making:

Peer pressure and interpersonal conflictThe impact of Board representation andcomposition on corporate performance


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Clearing out theInside view

The inside view fixation can be ameliorated

by an opposing outside view. This suggestsa clear role for non-executive directors.

But often too quickly they adopt the inside

view, not wishing to be obstructive toincumbent management, which appointedthem.


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THE SATISFACTION OF RECOGNITION- Hawthrone plant of Western Electriccompany.

It is nice to be noticed.

Inclusion in the elite group such as the

board of directors of a blue chip companyis something most would value and bereluctant to surrender once received.


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Financing Decisions

Heaton (2002):There is a relationship between excessiveoptimism and the pecking order theory that influences the

capital structure.

According to Heaton (2002), excessive optimism leads

managers to assume that their own companies are

undervalued.


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Graham (1999) : Questionnaire survey:

Majority of managers are convinced that their companies are

undervalued although the survey took place during the

Internet Boomat the end of the last century.

He attributes this finding tooverconfidence.

It explains the reluctance to issue new shares and the

preference for internal financing.


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Investment Decisions

Roll (1986):

Overconfidence leads to fostering takeovers.

Overconfidence, measured by the frequency executives

appear in thepublic, is positively related to the number of

takeovers.


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Porter and Singh (2010):

Managers overestimate synergies andunderestimate costs associated with

acquisitions.


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Landier and Thesmar (2009):

A survey of managers ofyoung firms

Majority have theoutlook for futuredevelopmentof the

firm will be positive.

Only 6 percent of the surveyed managers expect

difficulties.

Three years later, the managers evaluate the situation

more realistically: Now, already 17 percent of survey

participants expect future difficulties.


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Cost-estimationsof large-scale projects: Over optimistic

In retrospect costs are usually higher than initially

expected.Revenues, in contrast, are typically lower than originally

expected.

Both effectslead to the acceptance of unfavorable projects

due to excessive optimism.


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Malmendier and Tate (2005):

Compare the stock market development of firms run byawarded managers with a control group and discover

underperformance.

Reason:

Awarded managers are typically concerned with tasks

(writing books, amongst others) that detract them from more

important duties.

Another interpretation of the result is that winning awards

increases overconfidence.


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Most managers use asingle discountrate for all projects

within the firm.

questionnaire survey: fewer than 10 percent use different

discount rates for different projects.

A single discount rate: favors high-risk projects

discriminates low-risk projects.

Thus, the mentioned simplification results in suboptimal

investment choices. (boundedrationality)


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Prospect theory assumes that individuals are risk averse in

the positive and risk seeking in the negative domain.

between agambleand a sure loss, individuals tend to opt

for the gamble (Kahneman & Tversky, 1979).

Managers hold on to less successfulprojects even if those

projects should be finishedunder rational criteria (Fairchild,

2007).


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Hoping to break even, managers typically throw good moneyafter bad.

This phenomenon explains why thestock market reaction to

finishing announcements of loss-making projects is on

average positive(Statman & Sepe, 1989; Baker, Ruback &

Wurgler, 2004).


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Irrational Investors and

Rational Managers


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Rational managers balance between threegoals, namely

market timing,

catering and

increasing intrinsic value

(see Figure 2).


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Market timing relates to decisions that aim at exploiting

temporary mispricing, for example by issuing

overvalued or repurchasing undervalued shares.

Catering refers to decisions that aim at boosting stock

prices above the level of intrinsic value.

Increasing intrinsic value is self-explanatory.


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Financing Decisions

The fact thatnew issues underperform in the long run

spurs speculations that managers tend to issue

stocks, particularly if they are overvalued.


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Loughran and Ritter (1997)

Ikenberry, Lakonishok and Vermaelen(2000):

IPOs as well as SEOs have lower stockreturns than the aggregate market.

Issuing overvalued stocks lowers capitalcost at the expense of new investors.


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Loughran, Ritter and Rydqvist (1994) :

Number of IPOs is particularly high in times whenvaluation ratios indicate that the market is overvalued.


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These findings indicate that managers possess an

information advantage over investors and issue new

stocks if they are overvalued.


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In summary, investors should beskepticaltowards new

issues for at least two reasons:

First, newly issued shares underperform compared tothe aggregate market.

Secondly, newly issued shares are typically issued

when the aggregate market or the industry is at a high

or at an interim high.


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Repurchases:

Asked by Brav, Graham, Harvey and Michaely (2005):

Managers say that they consider undervaluation indeed

as an important criterion for repurchases.


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Investment Decisions

Shleifer and Vishny (2003) develop a theory for

corporate takeovers.

Firms undertake acquisitions if their own stocks are an

attractive currency to finance the purchase

Overvalued firms gain if they pay with own shares.

Undervalued firms, in contrast, should prefer to pay in

cash.


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A reason for stock acquisition:

Individual and even institutional investorsoftengive in to inertia and hold on to shares

in unwanted stock.

And therein lays opportunity for investment

managers and firms.


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So when another company uses stock toacquire a firm in which you hold a stake,what do you do with the new shares you

suddenly own of a company that you neverintended to buy in the first place?


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Logic suggests that you would be likely to

sell those shares.

Jeremy C. Stein:80 percent of individual investors and 30percent of institutional investors appear tobe more inertial than logical.

They take the default option, passivelyaccepting the shares offered as

consideration in stock mergers andacquisitions.


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A hypothetical company with a fixedstrategy that involves

acquiring another company

and building a new factory.

If the target and the factory each cost $100,and debt can only be used to finance one ofthe two transactions, how should theremaining $100 of equity be issued?


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If shareholders in the target areinertial, it is more cost-effective toraise equity in the context of amerger, and borrow money to buildthe factory, because supply ofshares in the market is constrained.


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The assumption of rational behavior is not realistic. Instead,

managers and investors make mistakes.

Recommendations for Managers

and Investors


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The question is how to prevent them. Debiasing is

difficult because the psychology that forms the basis of

those mistakes is very robust. Of course,individuals are

able to learn about biases but learning takes very long.


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Therefore, debiasing needs time and effort. Moreover the

complexity varies from situation to situation.

If feedback comes in fast and is clear, it is easier to realize

mistakes than if feedback comes in slow and is ambiguous.

In the selection of managers, investors should not only

consider managerial actions but also the motives behind

the actions.


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Managers frequently repurchase shares in order to

increase demand for price stabilization reasons.

Investors should be skeptical towards management that in

the past frequentlyengaged in takeoversthat proved to

be value destroying in retrospect.


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In this case, time and effort tofamiliarize investorswith

value increasing business principles pay off for the

management.


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Executives should confine themselves to value oriented

management. This would render earnings management

and other accounting manipulating actions

unnecessary.

However, informed investors are needed to provideincentives that ensure that not earnings manipulation

but value increasing actions pay off for managers.


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onclusion

Research in the field of Behavioral Corporate Finance

shows that managers as well as investors act irrationally

at least partly.

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8 c.behavioral Corporate Finance

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