8 C.behavioral Corporate Finance

How to Make Better Decisions?
Lessons Learned from

Behavioral Corporate
Finance
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 financial
markets. This means that stocks and bonds would be fairly
priced in every single moment.
In reality, however, rational behavior cannot be assumed for

either managers or investors.
Instead, Behavioral Corporate Finance : Several psychological
biases influence decision making of both groups.
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.
Many empirical studies discover

managerial behavior that is systematic.
irrational
overconfident and excessively optimistic (BenDavid, Graham & Harvey, 2010).

Anchoring, mental accounting and bounded
rationality (Baker, Ruback & Wurgler, 2004;
Gervais, 2010).
Table 1. Definition of biases (see also Shefrin, 2007)

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.
The irrational investor approach assumes that managers

possess an informational advantage over investors.
Seyhun (1992) confirms that managers are

well-informed:
He shows that they outperform the

market with legal insider trading (Baker &
Wurgler, 2012).
Muelbroek (1992) studies illegal insider
trading and also finds that managers earn
higher returns than the market.
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.
Psychological Barriers to
Arms Length Contracting
Jensen and Meckling model assumes that the
independent non-executive directors deal with the
senior management team at arms length.
Examining
the
explosion
of
executive
compensation, often in response to mediocre
performance, Bebchuk and Fried (2004) have
concluded this arms length contracting model
of corporate governance is largely fictional.
Reasons:
Interlocking directorships CEO of AAA Co. is on the board

of BBB Co. and the CEO of BBB Co. is on the board of AAA
Co.
Loyalty Often the CEO nominates or has a veto over
potential new independent directors. So, avoiding anything
that goes against your patron is highly probable.
CEOs are rather forceful people. So, confronting them could
be bruising and retaliation is 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 of
the company itself or companies in the same sector. So, the
big pay-packets and severance terms they received will be
questioned if they raise the same questions for the companies
in whose board they are now.
Group Psychology on the

Board, Building Consensus
and its Dissimulation
The centrality of group decision making:
Peer pressure and interpersonal conflict
The impact of Board representation and
composition on corporate performance
Clearing out the Inside view

The inside view fixation can be ameliorated
by an opposing outside view. This suggests
a clear role for non-executive directors.
But often too quickly they adopt the inside
view, not wishing to be obstructive to
incumbent management, which appointed
them.
THE SATISFACTION OF RECOGNITION

- Hawthrone plant of Western Electric
company.
It is nice to be noticed.
Inclusion in the elite group such as the
board of directors of a blue chip company
is something most would value and be
reluctant to surrender once received.
Financing Decisions
Heaton (2002):There is a relationship between excessive
optimism 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.
Graham (1999) : Questionnaire survey:

Majority of managers are convinced that their companies are
undervalued although the survey took place during the
Internet Boom at the end of the last century.
He attributes this finding to overconfidence.

It explains the reluctance to issue new shares and the
preference for internal financing.
Investment Decisions
Roll (1986):
Overconfidence leads to fostering takeovers.
Overconfidence, measured by the frequency executives

appear in the public, is positively related to the number of
takeovers.
Porter and Singh (2010):

Managers overestimate synergies and
underestimate costs associated with
acquisitions.
Landier and Thesmar (2009):

A survey of managers of young firms
Majority have the outlook for future development of 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.
Cost-estimations of large-scale projects: Over optimistic
In retrospect costs are usually higher than initially

expected.
Revenues, in contrast, are typically lower than originally
expected.
Both effects lead to the acceptance of unfavorable projects

due to excessive optimism.
Malmendier and Tate (2005):

Compare the stock market development of firms run by
awarded 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.
Most managers use a single discount rate 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. (bounded rationality)
Prospect theory assumes that individuals are risk averse in
the positive and risk seeking in the negative domain.

between a gamble and a sure loss, individuals tend to opt
for the gamble (Kahneman & Tversky, 1979).
Managers hold on to less successful projects even if those
projects should be finished under rational criteria (Fairchild,
2007).
Hoping to break even, managers typically throw good money

after bad.
This phenomenon explains why the stock market reaction to

finishing announcements of loss-making projects is on
average positive (Statman & Sepe, 1989; Baker, Ruback &
Wurgler, 2004).
Irrational Investors and

Rational Managers
Rational managers balance between three

goals, namely
market timing,
catering and
increasing intrinsic value
(see Figure 2).
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.
Financing Decisions
The fact that new issues underperform in the long run
spurs speculations that managers tend to issue
stocks, particularly if they are overvalued.
Loughran and Ritter (1997)

Ikenberry, Lakonishok and Vermaelen
(2000):
IPOs as well as SEOs have lower stock
returns than the aggregate market.
Issuing overvalued stocks lowers capital
cost at the expense of new investors.
Loughran, Ritter and Rydqvist (1994) :

Number of IPOs is particularly high in times when
valuation ratios indicate that the market is overvalued.
These
findings
indicate
that
managers
possess
an
information advantage over investors and issue new

stocks if they are overvalued.
In summary, investors should be skeptical towards new
issues for at least two reasons:
First, newly issued shares underperform compared to

the 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.
Repurchases:
Asked by Brav, Graham, Harvey and Michaely (2005):
Managers say that they consider undervaluation indeed

as an important criterion for repurchases.
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.
A reason for stock acquisition:

Individual and even institutional investors
often give in to inertia and hold on to shares
in unwanted stock.
And therein lays opportunity for investment
managers and firms.
So when another company uses stock to

acquire a firm in which you hold a stake,
what do you do with the new shares you
suddenly own of a company that you never
intended to buy in the first place?
Logic suggests that you would be likely to

sell those shares.
Jeremy C. Stein:
80 percent of individual investors and 30
percent of institutional investors appear to
be more inertial than logical.
They take the default option, passively
accepting
the
shares
offered
as
consideration in stock mergers and
acquisitions.
A hypothetical company with a fixed

strategy 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 of
the two transactions, how should the
remaining $100 of equity be issued?
If shareholders in the target are

inertial, it is more cost-effective to
raise equity in the context of a
merger, and borrow money to build
the factory, because supply of
shares in the market is constrained.
Recommendations for Managers

and Investors
The assumption of rational behavior is not realistic. Instead,
managers and investors make mistakes.
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.
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.
Managers frequently repurchase shares in order to

increase demand for price stabilization reasons.
Investors should be skeptical towards management that in

the past frequently engaged in takeovers that proved to
be value destroying in retrospect.
If capable managers encounter uninformed investors,

managers can try to give investors an understanding of
value oriented management.
An annual report:
Berkshire Hathaway provides a good example how loyal

investors can learn from management.
Here, shareholders are not considered faceless figures in an
ever shifting crowd. Instead they are treated as long-term
partners.
In this case, time and effort to familiarize investors with

value increasing business principles pay off for the
management.
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 provide

incentives that ensure that not earnings manipulation
but value increasing actions pay off for managers.
Conclusion
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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How to Make Better Decisions?

Lessons Learned from

managers and investors and its impacts on firm value.

In reality, however, rational behavior cannot be assumed for

Two types of research studies:

The first approach:

The second approach:

Many empirical studies discover

overconfident and excessively optimistic (BenDavid, Graham & Harvey, 2010).

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

The frequency of favorable outcomes is overestimated.

People anchor on an unimportant number and adjust

Deciding based on different mental accounts.

Decisions are not rational because individuals have

The irrational investor approach assumes that managers

Seyhun (1992) confirms that managers are

He shows that they outperform the

Irrational Managers and Efficient

Interlocking directorships CEO of AAA Co. is on the board

Group Psychology on the

Clearing out the Inside view

THE SATISFACTION OF RECOGNITION

According to Heaton (2002), excessive optimism leads

Graham (1999) : Questionnaire survey:

Internet Boom at the end of the last century.

He attributes this finding to overconfidence.

Overconfidence, measured by the frequency executives

Porter and Singh (2010):

Landier and Thesmar (2009):

Only 6 percent of the surveyed managers expect

Cost-estimations of large-scale projects: Over optimistic

In retrospect costs are usually higher than initially

Both effects lead to the acceptance of unfavorable projects

Malmendier and Tate (2005):

Most managers use a single discount rate for all projects

questionnaire survey: fewer than 10 percent use different

A single discount rate: favors high-risk projects

Thus, the mentioned simplification results in suboptimal

investment choices. (bounded rationality)

Prospect theory assumes that individuals are risk averse in

the positive and risk seeking in the negative domain.

Hoping to break even, managers typically throw good money

This phenomenon explains why the stock market reaction to

Irrational Investors and

Rational managers balance between three

Market timing relates to decisions that aim at exploiting

overvalued or repurchasing undervalued shares.

Increasing intrinsic value is self-explanatory.

Loughran and Ritter (1997)

Loughran, Ritter and Rydqvist (1994) :

information advantage over investors and issue new

In summary, investors should be skeptical towards new

issues for at least two reasons:

First, newly issued shares underperform compared to

when the aggregate market or the industry is at a high

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

Managers say that they consider undervaluation indeed

Overvalued firms gain if they pay with own shares.