13. Behavioral Corporate Finance Flashcards
What is corporate finance?
Corporate finance aims at explaining financial contracts and real investment behaviour that emerges from interaction of (i) managers and (ii) investors.
Understanding financing and investment patterns requires an understanding of beliefs and preferences of these 2 agents.
Traditional assumption: all agents are rational
Agents (investors and managers) are supposed to develop unbiased forecasts about future events and use these to make decisions that best serve their own (monetary) interests.
What is behavioural corporate finance?
Behavoural corporate finance replaces the traditional rationality assumptions with potentially more realistic behavioral assumptions.
Literature of BCF takes 2 different approaches:
1) Effect of investor behavior that is less than fully rational
2) Effect of managerial behavior that is less than fully rational
What is the irrational investors approach?
It assumes that arbitrage is imperfect, prices can be too high or too low (relative to national benchmark)
Rational managers are assumed to (i) perceive mispricings and (ii) to make decisions that encourage or respond to mispricing.
While the managers’ decision may maximize the short-run value of the firm, they may also result in lwoer long-run values as prices correct.
Managers balance 3 objectives: Fundamental value, catering and market timing.
What are the assumptions of irrational managers approach?
Managers have behavioural biases eg: overconfidence
This approach retains the rationality of investors, but limits the governance mechanisms they can employ to constrain the managers.
What is the irrational manager appraoch?
Malmendier and Tate (2005) study investment decisions of CEOs who overestimate the future returns of their companies.
Their argument: overconfident CEOs systematically overestimate the return to their investment projects.
Their model is a simple two period model.
The only friction in teh model comes from the manager’s inflated perception of the firm’s investment opportunities.
What is the irrational manager appraoch conclusion?
Overconfident CEOs overinvest and their investments are sensititive to the amount of cash and riskless debt available.
Empirical analysis: they analyze a sample of 477 large publicly traded US firms from the years 1980-1994 - cahs flow information, corporate investments, overconfidence measures.
They regress investment on cash flow and the overconfidence measure.
What are the overconfidence measures of the irrational manager appraoch?
Overconfidence measures: constructed using data on personal portfolio devisions of CEO’s.
Use the timing of option exercise as a measure.
Holder 67: option package held longer than vesting period even if percentage in-the-money is beyond a rational benchmark
Longholder: option package held until expiration date.
Net buyer: CEOs that buy their own company stock in the first 5 years of their contract.
Reslt: they finda strong positive correlation between the sensitivity of investment to cash flow and all measures of executive overconfidence.
Malmendier & Tate: 2005: CEO Overconfidence and Corporate Investment
What is the irrational investors approach?
Baker, Malcolm, Richard Ruback and Jeffrey Wurgler: “Behavioral Corporate finance: an updated Survey”.
Starting point: rational managers coexist with irrational investors: irrational investors influence securities prices - limits on arbitrage.
Managers are ‘smart’ int he sense of being able to distinguish market prices and fundamental value.
Why do we assume that corporate managers are smart in the sense of being able to identify mispricing?
Main reason for assumption in the literature.
Corporate managers have superior information about their own firm and projects.
What is the theoretical framework for the irrational investors approach?
Assume that markets are inefficient and managers are smart.
Three conflicting goals:
(1) Maximize fundamental value = selecting and financing investment project to increase the rationally risk-adjusted present value of future cash flows.
2) Maximize the current share price of the firm’s securities: in perfect capital markets.
3) Exploit the current mispricing for the benefit of existing, long-run investors.
How does market timing affect equity issues, repurchases in reality?
Several lines of empirical evidence suggests that overvaluation is a motive for equity issuance.
Graham and Harvey (2001) anonymous survey of CFOs: two thirds state that “the amount by which our stock is undervalued or overvalued was an important or very important consideration” in issuing equity.
The most popular response for all the repurchase questions on the entire survey is that firms repurchase when their stock is good value, relative to its true value: 86.6% of all firms agree.
Other works find postiive abnormal returns for firms that conduct repurchases, suggesting that managers are on average succesful in timing them.
What is the implication assumption of the traditional framework ?
Implication:
Managers can take for granted that capital markets are efficient, prices reflect public information about fundamental values.
Investors can take for granted that managers will act in their (monetary) self-interest, rationally responding to incentives shaped by compensation contracts.
What is the third goal of managers?
Exploit the current mispricing for the benefit of existing, long-run investors.
This is done by market timing financing policy whereby managers supply securities that are temporarily overvalued and repurchase those that are undervalueed. Such a transaction transfer value from the new or the outgoing investors to the ongoing, long-run investors. Transfer is realized in teh long run.
What is the second goal of managers?
2) Maximize the current share price of the firm’s securities: in perfect capital markets, this is the same as maximizing fundamental value - definition of market efficiency is that prices equal fundamental value.
Once one relaxes the assumption of investor rationality, the second objective is distinct.
In particular: the second goal is to cater to short term investors demands via particular investment projects or otherwise packaging the firm and its securities in a way that maximizes appeal to investors.
What is the model of Malmendier & Tate?
Overconfident CEO overestimates future returns by percentage delta, the perceived expected return: R(I)*(1+delta).
