BCF general Flashcards
what is the traditional vs behavioural finance views of managers and investors?
traditional finance = assumption mgrs and investors are rational and self interested
beh corp finance = real world view, mgrs and investors may be irrational
what is the difference between behavioural finance and behavioural corporate finance?
beh finance - investors irrational/biased (mgrial rationality taken as given). focus on capital market imperfections and inefficiency
beh corp finance - considers managerial irrationality and biases, focus on corp finance decisions.
how has behavioural finance developed since Simon’s bounded rationality (1955)?
economic experiments - humans not totally self-interested.
anomalies in efficient capital markets. excessive volatility and trading. over and under-reaction to news
80s - DeBondt coined term beh finance
prospect theory Tversky and Kahneman 80s
BF takes findings from psych, incorporates human biases into finance. which biases? potentially infinite:
bounded rationality /selfishness /willpower /emotions /social factors
how has behavioural corporate finance developed since the 80s?
researchers recognise biases that affect investors and financial markets also may affect mgrs and corporate decision-making.
what are the two main approaches to behavioural corporate finance?
irrational mgrs - taking investor rationality as given, e.g. mgrial overconfidence and corporate debt. assumes accurate pricing in financial markets.
irrational investors - affect on rational mgrs decisions (investment, financing, dividends), market timing and dividend catering, corporate name changes.
equity issues higher when sentiment high, overvalued, overselling. when undervalued, lots of repurchasing. (repurchase timing).
still within corporate decision making.
what are the focuses in BCF literature?
overconfidence/optimism
prospect theory and loss aversion
regret
what is managerial overconfidence?
psychologists: agents are more likely to be overconfident when task is very risky and outcomes are uncertain, when the task is complicated, when agents are committed to the task/project.
managers! – overconfidence higher with higher levels of education and experience.
evidence: gender effects, age and experience effects, confirmation bias.
what is confirmation bias?
risky outcomes are combination of skill and luck
good outcomes are attributed to skill, bad outcomes are attributed to bad luck and therefore discounted.
what is the effect of overconfidence on investment appraisal?
overestimate cashflow forecasts: overestimate mgerial ability/underestimate risk, gives upward bias to NPV
too many -ve NPV projects taken
goes against traditional arguments that mgrs take bad projects due to incentive problems.
what is the traditional view on how capital structure decisions are made?
perfect market conditions
traditional researchers brought in imperfections like mgrial agency problems/incentive problems:
asymmetric information (mgrs know more than investors).
debt disciplines mgrs to work harder, and is positive signal to the markets (so corporate structure relevant).
this has huge assumption that investors know this and are looking at debt as a +ve signal.
who argued overconfidence may induce firms to have excessive debt in capital structure? what was the argument?
shefrin -
having some debt increases effort as must make sure you can repay your debtors. too much leads to financial distress in stretching repayments. therefore there is an optimal level of debt, but overconfidence investors put in more effort. this means the optimal level of debt (that they perceive) will be higher, but financial distress costs may be more extreme. is there a trade-off as more effort goes in or is it value-reducing?
implication - overconfidence is value-reducing.
what are the arguments for and against overconfidence?
investment appraisal - too many -ve NPV projects
but: mgrs may be naturally risk-averse, therefore OC and risk aversion may offset each other.
capital structure
we have argued that overconfidence leads to increase in debt, possibly reducing firm value?
but Fairchild’s model = OC increases mgrial effort, increasing probability of success. therefore, ambiguous effect on firm value.
are venture capitalists overconfident?
Zacharakis finds vcs are overconfident in their assessments of entrepreneurs’ business plans. invest in too many bad ventures.
suggests formal ways of eliminating the overconfidence
how can bounded rationality be applied to investment appraisal?
many projects on mgrs desk to appraise
bounded rationality/rule of thumb/heuristics — mgr may only look at subset. good or bad?
may be missing out on good projects, but economising on effort and resources
what does bounded rationality in investment appraisal lead to?
NPV static, now or never approach.
real option approach - option to delay, expand and abandon.
flexibility in mgerial decision making, particularly valuable in face of extreme uncertainty, e.g. R&D.
project’s value-added = static NPV + RO value.
in real life, mgrs do not use real options much. behaviourally, status quo bias, cognitive dissonance, simply don’t like flexibility/decision making
