Module-4

Behavioural Corporate Finance

 Contents

Behavioural Corporate Finance

1. Introduction
2. Biases of behavioural corporate finance
3. Value Investing
4. Uses and Approaches of Behavioural Finance in Corporate decision making
5. RATIONAL MANAGERS WITH IRRATIONAL INVESTORS APPROACH
6. CAPITAL BUDGETING
1. Introduction
Behavioural Finance
Behavioural finance is the study of the effects of psychology on investors and financial
markets. It focuses on explaining why investors often appear to lack self-control, act against
their own best interest, and make decisions based on personal biases instead of facts.

Behavioural Corporate Finance

 Study of how owners and managers of publicly-traded companies make decisions that affect
the values of those companies.
 Examines effects of manager‟s and investor‟s psychological biases on firm corporate finance
decisions.
 Main psychological traps met are: narrow farming, confirmative bias, hindsight bias, herding
behavior conservatism, the role of affects, wishful thinking, opaque framing, representative
bias and overconfidence.

2. Biases of behavioural corporate finance

1. Overconfidence bias
2. Self-control bias
3. Confirmative bias
4. Hindsight bias
5. Herding bias
6. Representative bias
7. Narrow farming

1. Overconfidence bias
 Overestimate their ability to evaluate a company as potential investment.
 They trade excessively as a result of believing that they possess special knowledge that other
don‟t have
 Excessive trading behavior has proven to lead to poor returns over time.
 They don‟t know, don‟t understand or don‟t need historical investment performance
statistics; overconfident investors can underestimate their downside risk.
 They hold undiversified portfolios, thereby taking on more risk without change in risk
tolerance.
 Often overconfidence investors don‟t even know that they are accepting more risk than they
would normally tolerate.

2. Self-Control Bias
 It is a human behavioral tendency that causes people to consume today at the expenses of
saving tomorrow.
 Money is an area where people are notorious for displaying lack of self-control,
 The bias can be described as a conflict between people over-reaching.

3. Confirmative bias
The investor sometimes overlooks the negative news or information while being
overwhelmed with the positive side of the stock. Thus, ignoring the fact that this glittering
good news about the stocks may not possibly turn to be gold. In short, confirmation bias
takes place when making an investment decision; the investor behaves irrationally by
emphasizing on only the positive or the negative side of the stock.

4. Hindsight bias
Many investors seldom learn from their experiences and live upon the delusion of
knowing everything. This is where they often make mistake in analyzing certain investment
opportunity for their results and the forces driving towards such an outcome.

5. Herding bias
Herding bias also known as the 'bandwagon effect', is a psychological phenomenon in
which people rationalize that a course of action is the right one because 'everybody else' is
doing it. In the world of investment, this can take the form of panic buying or selling.

6. Representative bias
Representativeness bias is a type of mental shortcut we use to judge the probability of an
event or object. In other words, we jump to conclusions about something or someone on the
basis of how representative the particular case is. Representativeness is essentially
stereotyping when the similarity between events and objects confuse people regarding the
probability of an outcome.

7. Narrow farming
Many of the financial mistakes people make are caused by a fundamental shortcoming:
They can‟t see the big picture. In behavioral economics circles, this is known as “narrow
framing”-a tendency to see investments without considering the context of the overall
portfolio. Many people are vulnerable to it.
3. Value Investing:
 It is where people buy the stock when nobody is buying the stock.
 One of the reasons is that many stock investors do not understand what they are investing
in.
 That forces them to sell a good stock at a cheap price.
 In which, the practitioners of value investing will take advantage of that by buying the
stock they sold.
 Value investors seek to exploit the discrepancy between value and price. If the price is
significantly less than value, they buy. If the price exceeds value, they sell. For them, the
market is there to serve them, not to instruct them.

Value Investing Verses Stock Investing:

 Value investing is fundamentally different from stocks trading.
 While the latter focuses more on price movements and other technical indicators, the former
focuses on analyzing the business behind the stocks and buying the stocks at a cheap price.
 Value investing also generally has a longer time span than other kinds of investing.
 That is because it generally employs a buy and hold strategy until the value of the investment
plays out.

Value investing works because stock market is not efficient:

 Value investing works because simply put, the stock market is not efficient.
 That means that the stock market at points in time does not accurately reflect the true value
of the stock.
 Someone who practices Value Investing would usually shun away from ridiculously priced
stocks, even though the underlying business is good. That is because I am always reminded
that even buying a really good business at an expensive price would still constitute as a bad
investment.

Value investing and risks:

 Value investing is not without risks.
 When buying stocks with the idea that it is selling below its intrinsic value, a lot of personal
assumptions and judgements are required to come to that conclusion. There are risks that we
may be wrong in our judgement.
 Often times, stocks that look cheap via metrics such as price to earnings ratio or other
indicators may not be really “cheap”. There are risks that the earnings of the business will
continue to drop and as a result, the PE ratio of the business will increase– but the price of
the stocks remain the same or drop further. That is a trap that we must look to avoid.
Foreign exchange risks:
 Investment in US stocks by non US investors will expose them to foreign exchange risks.
 Even if the stock is doing well in US markets, changes in exchange rates will reduce the
profits when the amount is repatriated to home country at new exchange rates which have
moved up.
 It is important to remember that if the investment is made with personal money, the selling
decision can be postponed when rates are not favourable.
 Value investing is a long term game.

Understanding value investing:

 Value investing requires no particular intellect in a sense that anyone can learn it easily. The
mindset is as crucial or even more crucial to our investment success rather than our
knowledge of it.
 You need be patient and be willing to go against the crowd.
 You should also not borrow money to invest and only invest money you can afford not to use
for the next 5-10 years.
 Value investor invests in stocks of a good business provided the price is cheap relative to the
true value of the business.
 This is done through fundamental analysis plus patience.

Buying and selling:

 They key about selling is truly in selling a particular stock only when it is overvalued or that
our original reason for buying is not true anymore.
 The key to buying stocks is the margin of safety.
 Knowing that valuation of stocks in itself is an art and margin of safety allows some room for
error– which means that we need to buy the stocks at a cheap enough price.
 Remember, buying a good business at a high price is still a bad investment.

Influence of greed and fear on investing:

 Greed. When the investor has made good gains on his investment, he or she refuses to sell
the stocks because they are greedy for more gains.
 When there is counter evidence that says that a particular stock is overvalued, they look for
evidence to support their beliefs that it is not overvalued– thus, continue to hold it.
 Fear: You bought the stocks and the stock fell below the anchor point– the price you bought
it at. You feel scared that it will drop some more but you will not sell it because you are
afraid you will regret it if it goes up after you sell it.
 Again here, you look for evidence to support your belief that the stock price will rise above
your buying price. But the stocks continue falling and you refuse to admit your mistakes.
Conclusion:
 We should understand the impact of human behaviour in the stock market and hopefully via
that understanding, we would be able to invest in good value stock by being patient in
focusing on the long term investment results instead of short term market fluctuations.
 Using the impact of the human behaviour, more specifically on the fear of people, to use that
as a buying opportunity and using the greed of people, use that to sell our overvalued stocks.

4. Uses and Approaches of Behavioural Finance in Corporate

decision making

Firms raise funds by issuing equity, selling bonds, borrowing from banks and financial
institutions, issuing commercial paper, and generating operating cash flows.
Firms deploy funds by investing in fixed assets (land, buildings, plant and machineries),
engaging in mergers and acquisitions, building inventories, giving loans and advances,
paying interest, taxes, and dividends, and repurchasing shares.

Types of Corporate Financial Decisions:

i. Investment Decision
ii. Financing Decision
iii. Dividend Decision

i. Investment Decision:
A financial decision which is concerned with how the firm‟s funds are invested in different
assets is known as investment decision. Investment decision can be long-term or short-term.

Factors Affecting Investment Decisions / Capital Budgeting Decisions:

 Cash flows of the project-
 Rate of return
 Investment criteria involved
ii. Financing Decision:
A financial decision which is concerned with the amount of finance to be raised from various
long term sources of funds like, equity shares, preference shares, debentures, bank loans etc. Is
called financing decision. In other words, it is a decision on the „capital structure‟ of the
company.
Capital Structure Owner‟s Fund + Borrowed Fund

Factors Affecting Financing Decision:

 Cost
 Risk
 Flotation cost
 Cash flow position of the business
 Control considerations
 State of capital markets

iii. Dividend Decision:

A financial decision which is concerned with deciding how much of the profit earned by the
company should be distributed among shareholders (dividend) and how much should be retained
for the future contingencies (retained earnings) is called dividend decision.

Factors affecting Dividend Decision:

 Earnings
 Stability of dividends
 Growth prospects
 Cash flow positions
 Preference of shareholders
 Taxation policy

Corporate finance decision impact on balance sheet

 Shareholder‟s equity
 Long term loans
 Assets in place and growth assets
 Fixed assets -merges and acquisitions

There is Irrationality in decisions because of capital market(investors ,other parties, analysts

or rating agencies) or within firm (Shareholders, management)
 The above-mentioned decisions involve risk. The traditional approach to such decisions
focuses on value maximization using the discounted cash flow (DCF) analysis.
In DCF analysis, the expected cash flows associated with a decision are discounted at a
risk- adjusted discount rate to calculate the net present value. Decisions that have a positive
net present value are taken as they enhance firm value.

Traditional corporate finance provides powerful techniques that in theory help

managers in making decisions to maximize the value of their firms. Psychological pitfalls
hinder managers in applying these techniques correctly.
Behavioural Corporate Finance discusses various psychological pitfalls that affect corporate
financial decisions and offers suggestions on how to mitigate the impact of these pitfalls.
Corporate finance is primarily concerned with financial contracts and investment
behaviour that emerges from the interaction of managers and investors. The bulk of the
research in corporate finance assumes that these beliefs and preferences are fully rational.
Agents are expected to develop unbiased forecasts about future events and use these for making
decisions that best further their own interests. From a practical point of view, it means that
managers can assume that capital markets are efficient and hence prices rationally reflect public
information about intrinsic values. Similarly, investors can assume that managers will act in
their self-interest and respond rationally to incentives embedded in compensation contracts, the
market for corporate control, and other governance structures.

Behavioural corporate finance replaces the traditional rationality assumptions with

behavioural assumptions that are based on empirical evidence.

There are two broad approaches to behavioural corporate finance:

7. The first approach may be called the “rational manager with irrational investors”
approach. It assumes that while investors are irrational, managers are rational.
8. The second approach may be called the “managerial heuristics and biases” approach. It
assumes that managers are less than fully rational. The bulk of the research in the
“managerial heuristics and biases” literature has focused on the illusions of optimism and
overconfidence. Optimism means an overestimate of the mean ability or outcome and
confidence implies an underestimate of the variance of an outcome. In practice, of course,
there may be multiple channels of irrationality.

5. RATIONAL MANAGERS WITH IRRATIONAL INVESTORS

APPROACH

This approach assumes that market inefficiencies or mispricing exist and managers recognize
these mispricing to make decisions that exploit or further encourage mispricing. The decisions
that they take to maximize the short-term value of the firm, however, may lower the long-run
value of the firm when prices converge to fundamental values.

It appears that managers balance three objectives: fundamental value, catering, and market
timing. The first goal is to maximize the intrinsic (fundamental) value of the firm. This means
choosing and financing investment projects meant to increase the rationally risk-adjusted
present value of future cash flows.
The second goal is to maximize the current market value of the firm. In a perfect (efficient)
capital market, the first two objectives are the same, since market efficiency implies that price
equals fundamental value. However, when there is mispricing, managers try to “cater” to short-
term investor demands by choosing investment projects or financing packages or other actions
that maximize the appeal of the firm‟s securities to investors. Inter alia, catering may include:
 Investing in a particular technology that is currently hot.
 Adopting a conglomerate structure or a single-segment structure depending on what the
market fancies.
 Changing the name of the company. For instance, during the Internet craze of the late
1990s, many companies changed their names to “dotcom” names.
 Managing earnings.
 Initiating dividends.
 Issuing bonus shares or splitting shares.
 Acquiring companies by paying with overvalued stocks.

The third goal is to exploit the current mispricing for furthering the interest of existing,
long-term investors. This is done by resorting to a “market timing” financing policy. This
involves selling securities that are temporarily overpriced and repurchasing securities that are
temporarily underpriced. Such a policy transfers wealth from the new or the outgoing investors
to the ongoing long run investors. The wealth so transferred is realized as mispricing corrects
itself in the long run.

VALUATION
The standard valuation model for computing the intrinsic value of equity shares is
P0 = D1/(r – g) where D1 is the dividend expected a year from now, r is the discount rate, and g
is the constant growth rate applicable to dividends. The constant growth rate is obtained by
multiplying the ploughback ratio (the proportion of earnings that is retained by the firm) and
the return on equity.
There is an alternative approach to equity valuation that focuses on the growth opportunities
of the firm. This involves decomposing equity value into two components. The first component
represents the value of the firm when it pays its entire earnings as cash dividends. The second
component represents the (net) present value of growth opportunities (PVGO or NPVGO).
Under this approach, P0 = E1/r + PVGO. In this equation, P0 is the value per share, E1 is the
expected earnings per share over the next year, r is the discount rate, and PVGO is the NPV of
growth opportunities.
6. CAPITAL BUDGETING

Meaning

Capital budgeting is the process a business undertakes to evaluate potential major projects
or investments.
The process involves analyzing a project‟s cash inflows and outflows to determine whether
the expected return meets a set benchmark.
Capital budgeting involves three major steps.

 First, estimate the cash flows associated with the project.

 Second, compute the weighted average cost of capital (WACC). In calculating the
WACC, calculate the cost of equity using the capital asset pricing model and use market value
weights.

 Third, determine the net present value (NPV) of the project and accept it only if it’s NPV is
positive. The NPV of a project represents its contribution to the value of the firm. A close cousin
of NPV is the internal rate of return (IRR) criterion. It is the discount rate at which the NPV is
zero.

 Even though NPV is superior to IRR, in practice IRR has an edge over NPV. A comparison
of NPV, IRR, and the payback criteria suggests that the payback criterion is the most
intuitive whereas NPV is the least intuitive.

Payback criterion>IRR>NPV

Biases

 In addition to financial analysis, managers also rely on intuition, instinct, and gut feeling. They
want the decision to feel right emotionally.

 Overconfidence Often when managers supplant rigorous financial analysis with subjective
judgment, they underestimate project risk.
Two factors are mainly responsible for overconfidence in capital budgeting:
A. Perceived control - Psychologically, increased perceived control leads to lower perceived risk.
B. inadequate planning and risk management - People fail to engage in adequate risk planning
because when it comes to risk, out of sight is typically out of mind.

7. CAPITAL STRUCTURE
Modigliani–Miller tradeoff theory and Myers–Majluf pecking-Oder theory are the two main
approaches to capital structure.
The tradeoff theory considers the tradeoff between the tax shield provided by debt and
the financial distress associated with debt. Since interest on debt is tax-deductible, capital
structure has a bearing on the post-tax cash flows to the firm‟s investors. The value of the tax
shield provided by debt is generally estimated as the product of the amount of debt and the
corporate tax rate.
While debt provides tax shield, it imposes contractual obligations in the form of interest and
principal repayment. When a firm is unable to meet these obligations, it results in financial
distress that can potentially lead to bankruptcy. In a financially distressed firm manager
become myopic and sacrifice long term value creation at the altar of short-term survival.

According to the pecking order theory, there is a pecking order of financing which goes as
follows:
 Internal finance (retained earnings)
 Debt finance
 External equity finance

A firm first taps retained earnings. Its primary attraction is that it comes out of profits and
not much effort is required to get if. Further, the capital market ordinarily does not view the use
of retained earnings negatively.
When the financing need of the firm exceeds its retained earnings, it seeks debt finance.
As there is very little scope for debt to be mispriced, a debt issue does not ordinarily cause
concern to investors. Also, a debt issue prevents dilution of control.
External equity appears to be the last choice. A great deal of effort may be required in
obtaining external equity. More important, while retained earnings is not regarded by the
capital market as a negative signal, external equity is often perceived as „bad news.‟ Investors
generally believe that a firm issues external equity when it considers its stock overpriced in
relation to its future prospects.
Given the pecking order of financing, there is no well-defined target debt-equity ratio,
as there are two kinds of equity, internal and external. While the internal equity (retained
earnings) is at the top of the pecking order, the external equity is at the bottom. This explains
why highly profitable firms generally use little debt. They borrow less as they don‟t need much
external finance and not because they have a low target debt-equity ratio. On the other hand,
less profitable firms borrow more because their financing needs exceed retained earnings and
debt finance comes before external equity in the pecking order.

8. Dividend Policy
9. MERGER AND ACQUISTIONS (M&A)
A merger occurs when two separate entities combine forces to create a new, joint
organization. Meanwhile, an acquisition refers to the takeover of one entity by another.
Mergers and acquisitions may be completed to expand a company's reach or gain market share
in an attempt to create shareholder value.

The traditional approach to M&A assumes that the market prices of both the acquiring firm
and the target form reflect their intrinsic values, assuming that both remain as stand-alone
firms.

Behavioral Considerations
If markets are efficient and acquirers pay a premium which is less than the real synergistic
gains, acquisitions should create value for the shareholders of both the acquiring company and
the target company, regardless of the form (cash or stock) of compensation. Further, the level
of acquisition activity should not be a function of the level of the stock market.
Empirical evidence, however, suggests the following:
 Acquirers usually pay too much. This benefits the shareholders of the target company, but
hurts the shareholders of the acquiring company.
 CEOs falling love with deals and don‟t walk away when they should.
 Mergers and acquisitions thrive during periods of stock market buoyancy.
 Acquirerswhopaystockcompensationaremorelikelytodovalue-reducingdeals than acquirers
who pay with cash or debt.

The three main types of merger are:

A. Horizontal mergers which increase market share

B. vertical mergers which exploit existing synergies
C. concentric mergers which expand the product offering.

Example for M&A

The successful corporate marriage (merger) of Walt Disney and Pixar

Walt Disney is a media and entertainment company founded in 1923 by Walt

Disney and Roy Disney. Pixar was found in 1986 by Steve Jobs and is the pioneer
in animation. In 2006, Pixar was acquired by Walt Disney.

Some of the benefits of M&A deals have to do with efficiencies and others have to do with
capabilities, such as:
 Improved economies of scale. By being able to purchase raw materials in greater quantities,
for example, costs can be reduced.
 Increased market share. Assuming the two companies are in the same industry, bringing their
resources together may result in larger market share.
 Increased distribution capabilities. By expanding geographically, companies may be able to
add to their distribution network or expand its geographic service area.
 Reduced labor costs. Eliminating staffing redundancies can help reduce costs.
 Improved labor talent. Expanding the labor pool from which the new, larger company can
draw can aid in growth and development.
 Enhanced financial resources. The financial wherewithal of two companies is generally
greater than one alone, making new investments possible.

On February 3, 2000, Mannesmann board of directors accepted Vodafone's offer. Each

Mannesmann shareholder received 58.964 Vodafone shares which gave them 49.5% stake in the
new company. The deal was valued at approximately $180 billion. The new combined entity had
a market capitalization of $350 billion.

On May 5, 2006 the two esteemed companies Disney and Pixar merged. Disney acquired shares
worth $7.4 billion in Pixar and made it Disney's subsidiary. Since then it has been reported as
one of the most successful mergers of times.