Corporate Finance Slides Flashcards
What are the two main components of corporate finance?
Financing Decisions: security issuance, payout policy, and capital structure
Investment decisions: acquisitions or other investing activities
Capital Structure Overview
-It is overall irrelevant
-Tradeoff framework: balance costs and benefits of debt. The debt costs are bankruptcy costs and the benefits are leverage and tax benefits.
-Asymmetric Information: pecking order theory of payout: Internal Cash, Debt, and finally equity
How do rational managers respond to irrational investors?
Even if managers are rational they have to deal irrational investors. They might miss price securities below their intrinsic value.
-firms that issue securities preform poorly on average
-Ratio of equity issuance to total issuance in any year predicts subsequent market returns with a negative sign.
What qualities might becoming a senior manager engender?
While senior managers are often selected for rational decision-making, traits like overconfidence and optimism bias may actually help them rise. Once in power, executives may develop greater overconfidence, an illusion of control, and confirmation bias, believing their past success validates their future decisions—potentially leading to riskier or biased corporate behavior.
What are some managerial overconfidence implications?
Overconfident managers believe their firm’s stock is undervalued, making them reluctant to issue equity. This strengthens pecking order preferences (internal funds > debt > equity). They invest aggressively when cash flow is high, showing strong investment-cash flow sensitivity. Assuming an upward-sloping yield curve, they prefer short-term debt, underestimating refinancing risk due to overconfidence in firm performance.
Over precision in Corporate Finance
Researchers surveyed corporate executives about stock market return
probability distributions – realized market returns are within the executives’
80% confidence intervals only 36% of the time.
-Investment levels increase in the years following the start-date of
miscalibrated corporate executives.
-Miscalibration is associated with an increase in leverage. (Management
overestimates the probability of its firm’s capability to meet its liabilities.)
How would living through the Great Depression impact capital structures?
-Past experiences may affect one’s beliefs and/or preferences
-The Depression experience might discourage individuals from participating
in capital markets
-We see more debt conservatism among Depression CEOs
Sunk Cost Fallacy
-In fixed-exchange-ratio stock mergers, aggregate market fluctuations after
parties enter into a binding merger agreement induce variation in the final
acquisition cost
- These quasi-random cost shocks strongly predict firms’ commitment to an acquired business following deal completion, with an cost increases
significantly reducing subsequent divestiture rates by 8-9%.
- Concentrated in years in which the acquiring CEO is still in office.
CEO Turnover
CEOs are more likely to be fired after poor firm performance due to industry or market downturns—factors outside their control. This reflects the fundamental attribution error, where boards wrongly attribute external failures to internal causes. It also relates to outcome bias, where decisions are judged by results, not process quality.
-After exogenous changes in the CEO due to death or illness, value-
increasing layoffs are much more likely
-CEOs reluctance to make layoffs increases with their tenure at the firm
- Effect is amplified during recessions, for jobs near company headquarters,
and during the holiday season
-There seems to be a personal cost of firing for CEOs – accelerated long-
run mortality
Mergers
Returns to M&A activity are low – why do we see so much?
“Many managements apparently were overexposed in impressionable
childhood years to the story in which the imprisoned handsome prince is
released from a toad’s body by a kiss from a beautiful princess.
Consequently, they are certain their kiss will do wonders for the profitability
of the Target Company. We’ve observed many kisses, but very few
miracles. Nevertheless, many managerial princesses remain serenely
confident about the future potency of their kisses – even after their
corporate backyards are knee-deep in unresponsive toads.”
Overconfident CEOs (how could we measure overconfidence?) will do
more mergers – interestingly, they also do more diversifying mergers.
Entreprenuership
Entrepreneurship is often driven by overconfidence, optimism bias, and the illusion of control, which cause individuals to overestimate their odds of success. Identity-based rewards (autonomy, purpose) and emotional benefits also motivate risk-taking, despite low expected monetary payoff. Rational models alone can’t explain this; behavioral finance fills the gap.
Ultimatum Game
In the Ultimatum Game, a proposer offers a “take-it-or-leave-it” split of money; the responder can reject low offers out of fairness concerns. Rationally, any non-zero offer should be accepted, but anger and fairness perceptions often lead to rejection. Proposers must anticipate the responder’s emotions using Theory of Mind. Angry responders are especially prone to rejecting low offers, highlighting the role of emotion in decision-making.
Anger and Rational Thinking: How does anger influence decision-making and strategic reasoning?
Anger leads to heuristic processing, making individuals rely on fast, shallow thinking instead of deep, strategic reasoning. Angry people perform worse in strategic tasks (like beauty contest games) due to lower level-k thinking. In contrast, sadness promotes systematic, careful processing. Anger reduces rationality and can hurt negotiation outcomes.
Strategic Use of Anger
Two games one is strength based (anger is good) and one is cognitively demanding (anger is bad). IN the game the individuals are offered to anger their opponent by making them stay longer. Decision makers are more likely to say yes if it is a demanding task
-Providing an outlet for counterparties to express their negative emotions can decrease the use of costly punishment. This is shown in the ultimatum game where if the responder seems angry the sender will give a more favorable division in the ultimatum game
Strategic Use of Happiness
-Waiter smiles while handing over a check, displaying positive emotions while interacting with customers (leading to lower job satisfaction)
-They do it as customers give a higher tip when positive feelings are made salient. Proposer expresses more positive emotion in the ultimatum game more likely to accept the offer.
Avoiding Guilt
-As explored in the fraud slides promises may not just be cheap talk. Coming from guilt aversion as we want to think of ourselves as good people.
Negotiations
-expand the bounds of your bounded rationality (write down your goals beforehand)
-Scheduling- Try to be the first or last interview (primacy or recency effects)
-Leave lots of time for negotiation as cognitive dissonance can play into this.
-Prime counter parties- Use plural words and cooperative words to make it feel like a team.
-Be personable and mimic the counterparty, even offer a favor.
-Understand the counterparties interest or bring in a third party that can balance them
Negotiation- Pricing
Anchoring- Do not try and negotiate with ridiculous anchors. Backdown range offer, bracketing range offer, bolstering range offer, and finally bumped up point offer.
Framing- Segregate gains and integrate losses.
Negotiation Ending
Make a counteroffer can make counterparty happier, pause before accepting an offer. Compliment a counterparty.
