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Behavioral Corporate Finance

Behavioral Corporate Finance. Malcolm Baker Harvard Business School October 22, 2009. 1998: The market can stay irrational longer than you can stay solvent. 1999: Successful investing is anticipating the anticipations of others.

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Behavioral Corporate Finance

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  1. Behavioral Corporate Finance Malcolm Baker Harvard Business School October 22, 2009

  2. 1998: The market can stay irrational longer than you can stay solvent

  3. 1999: Successful investing is anticipating the anticipations of others

  4. 2008: If you owe a bank a hundred pounds, you have a problem, but if you owe a million, it has

  5. subject to

  6. Rational Fundamental Value

  7. There is no other proposition in economics which has more solid evidence supporting it than the Efficient Markets Hypothesis

  8. subject to

  9. Is this the way we make decisions? • Basis for individual investors’ intuition • Basis for well-capitalized investors’ strategies

  10. Is this the way we make decisions? • Basis for individual investors’ intuition

  11. The expert pool player makes shots as if he were a competent physicist and mathematician

  12. Temperature on March 12, March 24… April 5?

  13. How many people does P&G employ?

  14. H1N1 flu outbreak: You have two options

  15. Gamble: 50% chance $110; 50% chance -$100

  16. Retirement Plan Participation

  17. College GPA if your HS GPA was 2.2, 3.0, 3.8?

  18. Four examples • Categorization • Anchoring (expectations) and reference points (utility) • Inertia • Extrapolation

  19. Is this the way we make decisions? • Basis for individual investors’ intuition • Basis for well-capitalized investors’ strategies

  20. Competitive arbitrage forces prices to fundamental value; irrational traders die out

  21. MCI

  22. Entremed

  23. Royal Dutch and Shell

  24. United Airlines

  25. Why isn’t competition more effective? • Model risk • Noise trader risk • Unwinding or endogenous risk… comes from leverage • Funding risk and horizon… comes from e.g. impatient limited partners

  26. Volkswagen

  27. Is this the way we make decisions? • Basis for individual investors’ intuition • Basis for well-capitalized investors’ strategies

  28. Behavioral finance Investor errors • Categorization • Anchoring and reference points • Inertia • Extrapolation + Limits to arbitrage = Mispricing

  29. Capital structure, maturity structure, dividend/payout policy… are irrelevant in perfect markets

  30. Perfect Markets • The difference is no one ever thought markets were absolutely perfect • Taxes • Bankruptcy costs • Agency costs • Asymmetric information • But market efficiency and manager rationalityare largely ignored

  31. Behavioral Corporate Finance • Different sources of capital have different costs • For exogenous reasons, i.e. in inefficient capital markets with irrational traders • Firms respond in two ways • Market timing, catering • Real consequences for investment • Exogenously changing constraints

  32. Behavioral Corporate Finance, V. 1.0 • Corporate financing decisions appear to be timed well • Ritter (1991) and many more • Equity issues, stock-financed mergers, repurchases • Flows through to investment • Consistent with opportunism and real consequences of inefficient markets

  33. Managerial Smarts? • Information advantage • Meulbroek (1992) and several more on insider trading • Earnings management • Fewer constraints • Particularly in expanding supply • Accommodating investor demand • Rules of thumb, investment banking

  34. Behavioral Corporate Finance, V. 1.1 • Still the question of supply versus demand • Risk, growth opportunities • Use exogenous shocks to investor demand • Does the supply of capital, separate from fundamentals, affect investment?

  35. Some Examples • Instruments for the supply of capital • Flows into high-yield funds  investment by below investment grade firms • Chernenko and Sunderam (2009) • Many more examples like this emerging • Crisis parallel: securitization, screening  real estate, PE

  36. Behavioral Corporate Finance, V. 2.0 • Mounting evidence for supply effects • Independent of fundamentals • Still, it would be nice to tie this more closely to investor behavior • As opposed to e.g. institutional rigidities

  37. Back to Behavioral Finance Investor errors • Categorization • Anchoring and reference points • Inertia • Extrapolation + Limits to arbitrage = Mispricing

  38. Categorization and Dividend Policy • Test the hypothesis that investors categorize firms according to whether they pay a dividend • Remember March versus April • Four measures of a ‘dividend premium’ • Examine the corporate response

  39. Dividend Premium and Initiations Dividend Premium Propensity to Initiate Dividend Initiations

  40. Reference Points and M&A Pricing • Investors are reluctant to sell at a loss • Remember H1N1 experiment and loss aversion • Shefrin and Statman (1984) and Odean (1998) study individual investors • This means it’s hard to do a deal when a firm is selling well off its recent highs

  41. A Discontinuity in Offer Prices Offer Price = 52-week High Price Density (Offer Price – 52-week High Price) Pt-30

  42. A Discontinuity in Offer Prices Density (Offer Price – 52-week High Price) Pt-30

  43. Past High Prices and Average Offer Premia Offer Price  Pt-30 52-week High Price  Pt-30

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