finance discussion writing
Alok Kumar Department of Finance Miami Business School
akumar@miami.edu; 305‐284‐1882
FIN 686 Psychology of Financial Markets and Financial Decision Making
LECTURE NOTES 7
Corporate Finance: Traditional and Behavioral Perspectives
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We will start the behavioral corporate finance (BCF) portion of the course with an overview of traditional corporate finance theory. Next, we will preview several behavioral approaches to corporate finance which have developed in response to the assumptions necessary under the traditional framework. We will then discuss the implications of these approaches before delving deeper into the growing topic of BCF.
Corporate Finance What is corporate finance?
Aims to explain the financial contracts and real investment behaviors which emerge from the interactions of managers and investors
To understand firms’ financing and investment patterns, we need to understand the preferences and beliefs of these two agents
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Traditional Corporate Finance Some broad assumptions are typically relied upon in
neoclassical corporate finance theory… Beliefs and preferences of the agents (managers and
investors) are rational
Agents develop unbiased forecasts about future events and use these to make decisions that best serve their own interests
More practically, this means that managers can take for granted that capital markets are efficient Prices rationally reflect public information and fundamental
values
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Traditional Corporate Finance On the other hand, investors can assume that mangers will: Act in their own self‐interest, Rationally respond to: incentives shaped by compensation
contracts, Incentives/threats from the market for corporate control, And to other governance mechanisms
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Behavioral Corporate Finance These assumptions may not always hold…
For instance, investors’ behaviors may not be fully rational Firms/CEO’s could recognize this and respond accordingly
Or, managers may not always behave rationally This could lead to suboptimal policies within firms
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Behavioral Corporate Finance BCF investigates the implications if the assumptions
underpinning neoclassical corporate theory do not hold Overall, two main approaches have developed (and a third,
newer approach) 1. What are the effects on firms when investors are not fully
rational? • This is known as the Market Timing & Catering
approach 2. What are the effects on firms if managers are not fully
rational? • This is known as the Managerial Biases approach
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BCF: Market Timing & Catering This approach assumes that asset markets are imperfect,
and, as a result, prices can deviate from fundamental values (i.e., be too high or too low)
Rational managers recognize these mispricings and make decisions to exploit them (or encourage further mispricings) This can maximize short‐run firm value, but could also
result in lower long‐run values as prices converge back to fundamentals
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BCF: Market Timing & Catering Under this approach, managers make decisions by balancing
three objectives: Maximizing fundamental value Catering to the market (actions which boost share prices
above fundamentals) Market timing (financing decisions intended to capitalize
on temporary mispricings, generally issuing overvalued shares and repurchasing undervalued ones)
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BCF: Managerial Biases This approach assumes that managers are humans and are
subject to biases
Ultimately, these biases affect the decision making of CEO’s and can impact firm policies
But, this approach also depends on: Investor rationality but limited governance mechanisms Or investor irrationality (not paying attention)
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BCF: Behavioral Signaling Behavioral signaling models are a third, and newer approach,
to describe CEO’s behaviors (and as a response to traditional “signaling models”) Traditional signaling models assume rationality and
standard preferences and then use the destruction of firm value as a credible signal to investors
Good firms engage in costly behavior, which bad firms cannot copy, in order to show they are good firms
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BCF: Behavioral Signaling Behavioral signaling models rely on distortions in beliefs
and/or preferences as the mechanism
Example: Investors are loss‐averse over the level of dividends Therefore, a manager can raise dividends today to signal
he can meet/exceed that level going forward This will be too costly for bad managers (firms) to
replicate Ultimately, resulting in a higher value assigned to the
good manager (firm)
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BCF: Normative Implications
Before we delve further into the topic of behavioral corporate finance, it is worthwhile to think about the (differing) normative implications of the various approaches
For instance, considering these can give insights into why corporate finance is an important topic!
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BCF: Normative Implications Implications of the Market Timing & Catering approach… The primary source of irrationality is on the investor side This suggests that insulating managers from short‐term
share price pressures should facilitate firm value maximization
That is, managers need the flexibility to make decisions which may be unpopular in the marketplace in the short‐ run
In turn, this suggests that internal capital markets and barriers to takeovers will be beneficial
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BCF: Normative Implications Implications of the Managerial Biases approach… The primary source of irrationality is on the manager side This suggests that managers should be pushed
(obligated) to respond to market price signals In turn, this suggests that governance measures are
important
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BCF: Market Timing & Catering
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We will now look deeper into the Market Timing & Catering literature to gain insights into the dynamics between CEO’s, firms, and investors.
BCF: Market Timing & Catering The Market Timing & Catering framework is the most
developed, relative to the Managerial Biases and Behavioral Signaling frameworks
There are two key building blocks to the framework 1. Irrational investors influence securities prices (i.e.,
markets are not entirely informationally efficient and limits to arbitrage exist)
2. Managers recognize the mispricings that irrational investors have created and can/do respond
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BCF: Market Timing & Catering Over the first part of the course, we have seen that limits
to arbitrage exist and that investor sentiment can impact asset prices
But, even in the presence of limited arbitrage and systematic investor biases, is it reasonable for us to assume that managers are “smart” enough to recognize mispricings in their shares?
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BCF: Market Timing & Catering There are several justifications for thinking that managers
may be able to identify mispricings: Corporate managers have superior information about
their own firms ‐ insiders can make abnormal profits on their trades, both illegally (Muelbroek 1992) and legally (Seyhun 1992)
Managers can manufacture their own information by managing earnings (Bradshaw, Richardson, & Sloan 2006)
On the debt side, firms can exploit distortions in the yield curve by retiring and issuing debt advantageously (Greenwood, Hanson, & Stein 2010)
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BCF: Market Timing & Catering Overall, the underpinnings of the MT&C framework seem
reasonable
We will now look at the manager’s decision process in this setting
Managers make decisions by balancing three objectives: 1. Maximizing fundamental value 2. Catering to the market (actions which boost share prices
above fundamentals, generally short‐term) 3. Market timing (exploit the mispricings)
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BCF: Market Timing & Catering 1. Maximizing fundamental value This selecting and financing investment projects to
increase the risk‐adjusted present value of future cash flows
2. Maximize the current share price In perfect capital markets, this is the same as objective 1
since the definition of market efficiency is price equals fundamental value
But, if investors are not always rational, the second objective is distinct
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BCF: Market Timing & Catering 2. Maximize the current share price (continued) Under the MT&C framework, the second objective is to
“cater” to short‐term investor demands This can be done through investing in particular projects,
re‐packaging the firm’s shares (such as stock splits), instituting corporate policies (issuing dividends), rebranding the firm (changing the corporate name), etc…
Moreover, the determinants of mispricings can vary over time which suggests that managers’ responses can also be time‐varying (and thus firm policies can vary through time)
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BCF: Market Timing & Catering 3. Exploit the mispricings for the benefits of existing, long‐run
investors Managers aim to achieve this by “market timing”
financing policies That is, issue securities when shares are temporarily
overpriced and repurchase shares when they are undervalued (or less overvalued)
Ultimately, this impacts the firm’s capital structure
Overall, the MT&C framework has implications for firms’ investments, capital structure, and other corporate decisions
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MT&C – Investment Policies We will first look at how firm’s investment policies respond
to security prices…
Keynes (1936) argues that short‐term investor sentiment is a major determinant of firms’ investments through bubbles in asset prices That is, bubbles in asset prices can incite firms’ to
respond and over‐invest or under‐invest in particular projects
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MT&C – Investment Policies Put another way, the effective costs of various forms of
capital can change despite no changes in the firm’s fundamental characteristics
These changing costs can impact firm’s investment decisions For instance, if the cost of issuing equity suddenly
increases, firms may opt to forego the project instead of issuing equity
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MT&C – Investment Policies Firms which are undervalued by the market, and need equity
capital to finance new projects (equity‐dependent firms), may forego issuing shares and under‐invest (Stein 1996)
Baker, Stein, & Wurgler (2003) set out to test this Insight: When should the market matter? Standard corporate finance considerations suggest that
equity‐dependent firms will tend to be young, and to have high leverage, low cash balances and cash flows, high cash flow volatility (and hence low incremental debt capacity), but strong investment opportunities
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MT&C – Investment Policies Estimate firms’ levels of equity dependence based on
four variables: Cash Flow / BV of assets Cash Dividends / BV of assets Cash Balances / BV of assets Leverage
Higher score on the index suggests higher dependence on external equity to finance new projects
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MT&C – Investment Policies Four measures of investment: CAPEX / BV of assets, (CAPEX + R&D) / BV of assets (CAPEX + R&D + SG&A) / BV of assets Percentage change in BV of assets
Equity issuances: External equity issuances / start‐of‐year BV of assets
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MT&C – Investment Policies Investment policies of
firms which are highly dependent upon external equity capital to fund projects are nearly 3x as sensitive to stock prices compared to firms which are less dependent on equity capital
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MT&C – Investment Policies Polk & Sapienza (2009) predict that investment should be
more sensitive to short‐term mispricings when managerial and investors’ horizons are shorter They find that firms with high share turnover (where the
average shareholder’s investment horizon is shorter) have investment policies which are more sensitive to stock mispricings
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MT&C – Investment Policies Business Fixed Investment and Bubbles: The Japanese Case
(Chirinko & Schaller 2001)
Do managers take advantage of over‐valued shares and increase investment?
Setting: Japan From 1980 – 1989, the Japanese (US) stock market rose
373% (70%) From 1990 – 1993, the market fell by 50% Did managers issue equity/debt and increase
investment?
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MT&C – Investment Policies
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As the stock market rose, issuances of equity and bonds surged
And then fell in 1990 as the stock market crashed
MT&C – Investment Policies
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Business Fixed Investment and Bubbles: The Japanese Case (Chirinko & Schaller 2001)
The bubble in the Japanese stock market also boosted fixed investment by approximately 6 – 9% in the years 1987– 1989 This amounts to about 1 – 2% of GDP in each of these
three years
MT&C – Investment Policies Managers’ mergers/acquisition decisions may also be impacted by mispricings… For instance, if the CEO’s shares are over‐valued, he/she may
acquire another firm not to gain synergies, but to preserve some of the temporary overvaluation for long‐run investors Cushion the fall for long‐run shareholders when prices
move back to fundamentals by acquiring more hard assets
This is consistent with the evidence that cash acquirers earn positive long‐run returns (synergies) while stock acquirers earn negative long‐run returns (Loughran & Vijh 1997; Rau & Vermaelen 1998)
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MT&C – Investment Policies Managers’ mergers/acquisition decisions may also be impacted by mispricings
Market‐level mispricing proxies and merger volume are positively correlated (Dong, Hirshleifer, Richardson, & Teoh 2003; Ang & Cheng 2005) Within these firms, acquirers tend to be more
overpriced than targets
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MT&C – Investment Policies Managers’ mergers/acquisition decisions may also be impacted by mispricings…
Another interesting example is the bubble in shares of conglomerate firms in the late 1960’s– 70’s The avg. return across 13 large conglomerate firms was
385% from July 1965 to June 1968; the S&P gained 34% Diversifying acquisitions experience a positive
announcement effect (other acq. were penalized) Conglomerates enjoyed a “Diversification Premium” of 36%
from 1966‐68 Conglomerate mergers accelerated in 1967 and peaked in 1968
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MT&C – Investment Policies Managers’ mergers/acquisition decisions may also be impacted by mispricings…
Conglomerate valuations plummeted starting in late‐1968 68% loss b/t July 1968 and June 1970 (3x more than S&P) Diversification Premium turned into a 1% discount (1969‐
71) and 17% in 1972‐74 Diversification merger announcements received negative
market reactions Firms then shifted towards spinning‐off unrelated business
segments
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MT&C – Financing Policies Mispricings may impact CEO’s decisions to issue or repurchase shares (or debt). That is, they may behave opportunistically…
The evidence points toward over‐valuation being an important motive for equity issuances… Graham and Harvey (2001): anonymous survey of CFO’s of
public companies Two‐thirds state that stock under‐/over‐valuation is an
important consideration when issuing equity Pagano, Panetta, and Zingales (1998) show firm’s IPO
decisions are dependent upon the valuations of public companies in the same industry Higher market‐to‐book ratios lead to more IPO’s
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MT&C – Financing Policies The evidence points toward over‐valuation being an important
motive for equity issuances… (continued) IPO volume and stock market valuations are highly correlated
in most stock markets around the world (Loughran, Ritter, & Rydqvist 1994)
Rising equity values tilt firms toward conducting seasoned equity offerings instead of issuing debt (Marsh 1982; Jun et al. 1996; Erel et al. 2010)
But, long‐run (5yrs) returns post‐IPO are 30% lower than comparable, already public firms. SEO’s returns are 29% lower.
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MT&C – Financing Policies The evidence points toward over‐valuation being an important
motive for equity issuances… (continued) Insider selling also coincides with seasoned offerings (Jenter
2005)
The evidence points toward under‐valuation being an important motive for equity repurchases… Repurchasers tend to earn positive abnormal returns
(Ikenberry, Lakonishok, & Vermaelen 1995) 12% more than similar, non‐repurchasing firms
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MT&C – Financing Policies Overall, there is growing evidence that managers tend to
issue equity before low returns and repurchase shares before returns are higher (i.e., they time financing policies to take advantage of mispricings)
Managers also time debt issuances with low interest rate environments (Graham & Harvey 2001; Marsh 1982; Guedes and Opler 1996; Baker et al. 2003)
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MT&C – Catering CEO’s may also adjust their decisions to take advantage of
changes in investors’ preferences
That is, they identify investors’ changing preferences and then cater their firms’ policies to take advantage
A ready example are firm’s dividend policies…
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MT&C – Catering Investors' preferences for dividends can vary across both
forms of dividends (cash vs. stock) and through time
These changing preferences can lead to variation in demand for the shares of firms which pay (or do not pay) dividends, and thus, impact stock prices
Managers may recognize these changing preferences and adapt their firms’ dividend policies
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MT&C – Catering First, do investors’ preferences for dividends vary? Yes! Long (1978): Citizens Utilities had two types of shares One type paid cash dividends, the second type paid
stock dividends However, the value of the payouts was the same Therefore, the shares should trade at the same price
(Law of One Price) However, shares frequently traded at significantly
different prices!
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MT&C – Catering There is also time (and geographic) variation in the
demand for dividend paying firms At times, dividend payers trade at a premium: (Avg. book‐
to‐market value of dividend payers) – (Avg. book‐to‐ market value of non‐payers)
When the dividend premium is high (low), firms tend to initiate (omit) dividend payments (Baker and Wurgler 2004)
This results in an increase in the firms’ short‐run nominal share prices
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MT&C – Catering Name changes provide another opportunity to examine firms’
catering to investors’ preferences
That is, a firm’s name should be irrelevant in frictionless and efficient markets
Moreover, there is some cost to changing a name
Therefore, firms which change names must do it for a reason Perhaps to create a salient association with a temporarily
overpriced category of stocks
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MT&C – Catering We see numerous name changes when a particular
industry/firm‐type is experiencing a bubble in prices
Electronics boom in 1959‐62: Firms changed their names to include “ ‘troncis ”
Dotcom bubble in late‐1990’s: 147 firms changed their names to include “dotcom” between Jun 1998 and July 1999 Even if the firm was not associated with the Internet, the
announcement effect was a 74% increase on average After the crash (Aug. 2000 – Sep. 2001), firms which
dropped “dotcom” from their names saw a price spike of 70% (even if the firm was associated with the Internet or had just recently added “dotcom” to its name)
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MT&C – Catering Firms also cater to investors’ preferences for shares that trade in
a “reasonable” nominal price range The avg. share price has been about $25 since the Great
Depression (Dyl & Elliott 2006; Weld et al. 2009) IPO’s and shares of open‐end mutual funds have also
remained relatively constant This is despite large devaluation of the US dollar These relatively static nominal prices may be due to
mangers catering to investors Baker, Greenword, & Wurgler (2009): when low‐price firms
trade at a premium, there is a higher propensity for firms to split their shares (IPO’s avg. prices also follow the premium closely)
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Summary and Conclusion
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Overall, there is mounting evidence that managers adjust firm policies to cater to investors’ preferences These actions can raise firms’ share prices, at least
temporarily
Managers also seem to take advantage of changing preferences or demands (e.g., when stock prices are experiencing a bubble) and adapt their firms’ financing and investment policies That is, managers time firms’ capital raising activities with
movements in capital markets This ultimately impacts firms’ investments