Behavioral Corporate Finance 1 Outline Rational
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Behavioral Corporate Finance 1 Outline Rational Corporations in Irrational Markets Financial Decisions: Equity offerings, Debt issues, and Dividend policy Investment Decisions: Real investment Managerial biases Financial decisions
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Behavioral Corporate Finance 1<br>
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Outline Rational Corporations in Irrational Markets
Financial Decisions: Equity offerings, Debt issues, and Dividend policy
Investment Decisions: Real investment
Managerial biases
Financial decisions
Investment Decisions: Real investments 2<br>
Financial Decisions: Equity offerings, Debt issues, and Dividend policy
Investment Decisions: Real investment
Managerial biases
Financial decisions
Investment Decisions: Real investments 2<br>
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Rational Corporations-Financial decisions Rational Corporations: Managers behave rationally and attempt to take advantage of investors’ irrationality and temporary market anomalies.
Financial Decision: Financial decisions of rational managers in the irrational markets are about catering to investor taste and market timing, that is, supplying the market with instruments that investors are particularly fond of at a given moment in time and taking advantage of temporary mispricing. 3<br>
Financial Decision: Financial decisions of rational managers in the irrational markets are about catering to investor taste and market timing, that is, supplying the market with instruments that investors are particularly fond of at a given moment in time and taking advantage of temporary mispricing. 3<br>
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Rational Corporations-Financial decisions Equity Offerings
IPOs: IPOs tend to cluster both in time and in sectors. This kind of clustering could be due to the clustering of real investment opportunities. Private firms may also decide to go public when listed firms from the same sector are valued favorably.
The IPO market timing hypothesis is supported by the evidence of poor post-IPO performance both in terms of operational results and negative 4<br>
IPOs: IPOs tend to cluster both in time and in sectors. This kind of clustering could be due to the clustering of real investment opportunities. Private firms may also decide to go public when listed firms from the same sector are valued favorably.
The IPO market timing hypothesis is supported by the evidence of poor post-IPO performance both in terms of operational results and negative 4<br>
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Rational Corporations-Financial decisions abnormal post-IPO stock returns.
SEOs: SEOs also tend to be driven by temporary market overvaluation. The SEOs market timing hypothesis are also supported by poor post-SEO returns.
The hypothesis of market overvaluation as one of the key drivers of equity issuance is strongly supported by survey evidence. 5<br>
SEOs: SEOs also tend to be driven by temporary market overvaluation. The SEOs market timing hypothesis are also supported by poor post-SEO returns.
The hypothesis of market overvaluation as one of the key drivers of equity issuance is strongly supported by survey evidence. 5<br>
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Rational Corporations-Financial decisions Debt issue
Market timing of debt issuances is related to two general aspects: (1) decisions to issue new debt when its cost is unusually low and (2) choices between issuing short- and long-term debts.
The willingness to issue debt depends also on company valuation. If the stock is highly overvalued, the firm may decide to finance with equity rather than debt even if the cost of debt is low. 6<br>
Market timing of debt issuances is related to two general aspects: (1) decisions to issue new debt when its cost is unusually low and (2) choices between issuing short- and long-term debts.
The willingness to issue debt depends also on company valuation. If the stock is highly overvalued, the firm may decide to finance with equity rather than debt even if the cost of debt is low. 6<br>
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Rational Corporations-Financial decisions Survey evidence offers support for market timing being a factor in debt issuance decisions. CFOs interviewed by Graham and Harvey (2001) admitted that they issue debt when they think “rates are particularly low”.
Debt maturity: Survey evidence also shows that managers pick short-term debt “when short-term rates are low compared to long-term term rates” and “when waiting for long-term rates to decline”. 7<br>
Debt maturity: Survey evidence also shows that managers pick short-term debt “when short-term rates are low compared to long-term term rates” and “when waiting for long-term rates to decline”. 7<br>
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Rational Corporations-Financial decisions Debt maturity shows a strong negative relation to the difference between long and short-term bond yields (term spread)(Guedes and Opler, 1996: 7,369 debt issues in the United States between 1982 and 1993)
Baker, Greenwood, and Wurgler(2003): They find a negative relation between the cumulative share of long-term debt issues in total (long and short) debt issues and the term spread. 8<br>
Baker, Greenwood, and Wurgler(2003): They find a negative relation between the cumulative share of long-term debt issues in total (long and short) debt issues and the term spread. 8<br>
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Rational Corporations-Financial decisions Dividend Policy
Fama and French (2001): The proportion of dividend-paying firms has been declining since 1960s. Dividends are primarily paid by large and well-established firms with low idiosyncratic risk and relatively lower market risk.
Investors consider dividend initiation (omissions) as a good (bad) signal. Stock prices react positively to dividend initiation and negatively to announcements of dividend omissions. 9<br>
Fama and French (2001): The proportion of dividend-paying firms has been declining since 1960s. Dividends are primarily paid by large and well-established firms with low idiosyncratic risk and relatively lower market risk.
Investors consider dividend initiation (omissions) as a good (bad) signal. Stock prices react positively to dividend initiation and negatively to announcements of dividend omissions. 9<br>
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Rational Corporations-Financial decisions Because of the strong adverse market reaction to dividend omissions or declines, managers consider dividend payout as a sticky decision, which might be costly to reverse.
Managers are cautious about initiating or increasing dividend payments unless they are convinced that the firm will be able to maintain the payout policy. As the market reaction to dividend announcements is asymmetric, managers also tend to smooth the payments over time. 10<br>
Managers are cautious about initiating or increasing dividend payments unless they are convinced that the firm will be able to maintain the payout policy. As the market reaction to dividend announcements is asymmetric, managers also tend to smooth the payments over time. 10<br>
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Rational Corporations-Financial decisions The catering theory of dividend proposed by Baker and Wurgler (2004a): The theory can be seen as a special case of managers adapting their policy to the clientele, where the “clientele” is changing due to its own dynamic preferences.
Investor sentiment and demand for dividend stocks vary over time causing differences in relative valuation of payers and non-payers. Trying to exploit this mispricing, managers respond with shifts in their dividend policy. 11<br>
Investor sentiment and demand for dividend stocks vary over time causing differences in relative valuation of payers and non-payers. Trying to exploit this mispricing, managers respond with shifts in their dividend policy. 11<br>
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Rational Corporations-Financial decisions To determine the relative valuation of payers and nonpayers, Baker and Wurgler use a measure called the dividend premium, which is the difference between the average market-to-book ratios of payers and non-payers.
They argue that firms initiate dividends when the existing payers are trading at a premium to non-payers. On the other hand, dividends are more likely to be omitted when payers are traded at a discount. 12<br>
They argue that firms initiate dividends when the existing payers are trading at a premium to non-payers. On the other hand, dividends are more likely to be omitted when payers are traded at a discount. 12<br>
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Rational Corporations-Investment decisions Real investment
There are various ways in which irrational investor sentiment may influence decisions of rational managers about real investment.
Stock and debt markets affect investment through their influence on the cost of funds.
Managers may make their decisions catering to investors’ beliefs and temporary preferences. Catering may take the form of increasing the scale of investment when investors favor growth 13<br>
There are various ways in which irrational investor sentiment may influence decisions of rational managers about real investment.
Stock and debt markets affect investment through their influence on the cost of funds.
Managers may make their decisions catering to investors’ beliefs and temporary preferences. Catering may take the form of increasing the scale of investment when investors favor growth 13<br>
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Rational Corporations-Investment decisions and under-investing when investors are skeptical.
The full effect of an investment project on a firm’s fundamentals may be usually observed only in a longer period of time. However, if biased investors attach too much weight to current information about new investment, managers may use investment decisions also for short term purposes.
The empirical evidence on the link between stock prices and investment is mixed. 14<br>
The full effect of an investment project on a firm’s fundamentals may be usually observed only in a longer period of time. However, if biased investors attach too much weight to current information about new investment, managers may use investment decisions also for short term purposes.
The empirical evidence on the link between stock prices and investment is mixed. 14<br>
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Rational Corporations-Investment decisions Rather than controlling for fundamentals and looking for a residual effect of stock prices, various proxies for mispricing are used and then the relations between these proxies and investment are examined.
Polk and Sapienza (2009) use discretionary accruals, a measure of the extent to which the firm has abnormal noncash earnings, to identify mispricing. 15<br>
Polk and Sapienza (2009) use discretionary accruals, a measure of the extent to which the firm has abnormal noncash earnings, to identify mispricing. 15<br>
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Rational Corporations-Investment decisions Firms with high discretionary accruals have subsequently lower stock returns, suggesting that they are overpriced. Polk and Sapienza regress firm-level investment on discretionary accruals and find a significant positive relation between the two variables.
Baker and Wurgler (2007) propose the sentiment index as a proxy for misvaluation. McLean and Zhao (2014) use that measure and show that investor sentiment has a significant impact on firms’ investment decisions. 16<br>
Baker and Wurgler (2007) propose the sentiment index as a proxy for misvaluation. McLean and Zhao (2014) use that measure and show that investor sentiment has a significant impact on firms’ investment decisions. 16<br>
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Rational Corporations-Investment decisions The relation between internal cash flow and investment declines with the growth of sentiment.
Firms tend to overinvest in high sentiment states. Stock returns following investment made in high sentiment states are significantly lower than those made in low sentiment periods.
Stein (1996), Baker, Stein, and Wurgler(2003): Mispricing driven investment is most sensitive in equity-dependent firms. 17<br>
Firms tend to overinvest in high sentiment states. Stock returns following investment made in high sentiment states are significantly lower than those made in low sentiment periods.
Stein (1996), Baker, Stein, and Wurgler(2003): Mispricing driven investment is most sensitive in equity-dependent firms. 17<br>
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Rational Corporations-Investment decisions Particularly, if stock of such firms is undervalued, managers are likely to underinvest rather than issue equity below its fair value.
Kusnadi and Wei(2017)
Three hypotheses related to equity-financing and catering channel (p.238-239)
Data and variables
(1) Measures of corporate investment 18<br>
Kusnadi and Wei(2017)
Three hypotheses related to equity-financing and catering channel (p.238-239)
Data and variables
(1) Measures of corporate investment 18<br>
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Rational Corporations-Investment decisions (2) Measures of mispricing 19<br>
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Rational Corporations-Investment decisions (3) Measures of equity-dependent:
Financial flexibility Index: A firm is assigned a value of 1 if its CASH or DIV value is greater than the 75% percentile, or its CAPX is below the 25% percentile.
(4) Country-level data: ACCESS, TURNOVER, and RD; DEV
The equity-financing channel (H1)
Baseline regression: eq.(6)
Table 3 panel A~C 20<br>
Financial flexibility Index: A firm is assigned a value of 1 if its CASH or DIV value is greater than the 75% percentile, or its CAPX is below the 25% percentile.
(4) Country-level data: ACCESS, TURNOVER, and RD; DEV
The equity-financing channel (H1)
Baseline regression: eq.(6)
Table 3 panel A~C 20<br>
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Rational Corporations-Investment decisions (1) The financial flexibility index (FF) is used as the inverse measure of equity dependence to test H1. H1 predicts that the sensitivity of corporate investment to stock prices should decrease (increase) with the degree of financial flexibility (equity dependence). That is, b should decrease with FF quartiles.
(2) Panel A: The coefficient on Q decreases from 5.194 in the bottom FF quartile to 0.075 in the top FF quartile. Besides this difference is significant. 21<br>
(2) Panel A: The coefficient on Q decreases from 5.194 in the bottom FF quartile to 0.075 in the top FF quartile. Besides this difference is significant. 21<br>
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Rational Corporations-Investment decisions (3) Corporate investment is significantly more sensitive to stock prices for less financially flexible firms than for more financially flexible firms. That is, the sensitivity of investment to stock prices declines with the degree of financial flexibility.
Alternative specification to test H1: Estimate regression (7) for the pooled sample. The coefficient of interest in b1 and this interaction coefficient is expected to be negative. (Table 3 Panel D) 22<br>
Alternative specification to test H1: Estimate regression (7) for the pooled sample. The coefficient of interest in b1 and this interaction coefficient is expected to be negative. (Table 3 Panel D) 22<br>
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Rational Corporations-Investment decisions (1) The coefficient of the interaction term, b1, is negative and highly significant for all three measures of corporate investment at the 1% level. More specifically, b1 is -2.148, -1.922, and -2.792, when the dependent variable is CAPX, CAPXRD, and CAPXRDA, respectively.
(2) In summary, the empirical results in Table 3 are consistent with H1 and extend the findings of Baker et al. (2003) to international sample.
Inclusion of alternative measures of growth 23<br>
(2) In summary, the empirical results in Table 3 are consistent with H1 and extend the findings of Baker et al. (2003) to international sample.
Inclusion of alternative measures of growth 23<br>
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Rational Corporations-Investment decisions The catering channel (H2)
First, partition the whole sample into two sub-samples according to the median value of ACCESS, TURNOVER, or RD, or whether the dummy variable DEV is 0 or 1. Then estimate Eq. (6) for the two sub-samples.
The prediction from the first part of H2 is that the sensitivity of corporate investment to stock prices is higher (lower) in countries where the cost of raising external equity is lower (higher). 24<br>
First, partition the whole sample into two sub-samples according to the median value of ACCESS, TURNOVER, or RD, or whether the dummy variable DEV is 0 or 1. Then estimate Eq. (6) for the two sub-samples.
The prediction from the first part of H2 is that the sensitivity of corporate investment to stock prices is higher (lower) in countries where the cost of raising external equity is lower (higher). 24<br>
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Rational Corporations-Investment decisions (1)Table 7(Panel A: ACCESS and DEV) Consistent with predictions of H2, sensitivities of investment to stock prices (as measured by b) are higher for firms located in countries with a high score on ACCESS, and for firms in developed markets.
(2)When ACCESS is used as a measure of external-financing costs, the estimated coefficient of b increases from 1.456 in the low sub-sample to 4.291 in the high sub-sample. Both coefficients are statistically significant at the 1% level. 25<br>
(2)When ACCESS is used as a measure of external-financing costs, the estimated coefficient of b increases from 1.456 in the low sub-sample to 4.291 in the high sub-sample. Both coefficients are statistically significant at the 1% level. 25<br>
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Rational Corporations-Investment decisions (3) Investment is also significantly more sensitive to stock prices for firms in developed markets (with b=4.056) than for firms in emerging markets (b=1.602).
The second part of H2 predicts that corporate investment is also more sensitive to stock prices for firms located in countries where shareholders have shorter horizons and for firms whose average assets are more opaque. 26<br>
The second part of H2 predicts that corporate investment is also more sensitive to stock prices for firms located in countries where shareholders have shorter horizons and for firms whose average assets are more opaque. 26<br>
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Rational Corporations-Investment decisions (1) Table 7 (Panel A: TURNOVER, RD)
TURNOVER is used an inverse measure of average shareholder horizons and RD as a direct measure of asset opacity.
(2) When TURNOVER is the partitioning variable, the sensitivity of investment to stock prices is 3.948 for the high TURNOVER firms and 1.942 for the low TURNOVER firms. When RD is the partitioning variable, the sensitivity of investment to stock prices is 3.933 for the high RD firms and 1.843 for the low RD firms. 27<br>
TURNOVER is used an inverse measure of average shareholder horizons and RD as a direct measure of asset opacity.
(2) When TURNOVER is the partitioning variable, the sensitivity of investment to stock prices is 3.948 for the high TURNOVER firms and 1.942 for the low TURNOVER firms. When RD is the partitioning variable, the sensitivity of investment to stock prices is 3.933 for the high RD firms and 1.843 for the low RD firms. 27<br>
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Rational Corporations-Investment decisions An alternative specification to test H2. Estimate the regression (8) for the pooled sample.
(1)COUNTRY is a dummy variable that equals 1 for countries with a high score on ACCESS, TURNOVER, or RD, and for developed countries; and 0 otherwise.
(2)The coefficient of interest in this case is the coefficient on the interaction term between Q and COUNTRY, b2. H2 predicts that the coefficient of b2 should be positive. 28<br>
(1)COUNTRY is a dummy variable that equals 1 for countries with a high score on ACCESS, TURNOVER, or RD, and for developed countries; and 0 otherwise.
(2)The coefficient of interest in this case is the coefficient on the interaction term between Q and COUNTRY, b2. H2 predicts that the coefficient of b2 should be positive. 28<br>
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Rational Corporations-Investment decisions (3)Table 7 (Panel B). Consistent with the findings in Panel A of Table 7, the coefficients of the interaction term (b2) are all positive and significant at the 1% level.
(4)The results suggest that the non-fundamental component of stock prices is a better predictor of investment for firms in countries where the costs of raising external equity are lower, or where the average shareholder horizons are shorter, or for firms whose assets are more difficult to evaluate. 29<br>
(4)The results suggest that the non-fundamental component of stock prices is a better predictor of investment for firms in countries where the costs of raising external equity are lower, or where the average shareholder horizons are shorter, or for firms whose assets are more difficult to evaluate. 29<br>
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Rational Corporations-Investment decisions The joint roles of the equity-financing and catering channels (H3)
Test whether the ability of managers to exploit the mispricing in stock prices is attenuated or intensified in countries with a lower external equity-financing cost.
Use the partitioned samples based on each of the country-level variables and re-estimate eq.(7) for each of the subsample. The results are reported in Panel A of Table 8. 30<br>
Test whether the ability of managers to exploit the mispricing in stock prices is attenuated or intensified in countries with a lower external equity-financing cost.
Use the partitioned samples based on each of the country-level variables and re-estimate eq.(7) for each of the subsample. The results are reported in Panel A of Table 8. 30<br>
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Rational Corporations-Investment decisions (1)When ACCESS is used as the country-level partitioning variable, the coefficient on the interaction term Q*FF is more negative in the high ACCESS sub-sample(-2.070) than in the low ACCESS sub-sample(-1.329).
(2)The effect of the equity-financing channel is also significantly stronger for firms in the developed markets (coefficient on Q*FF=-2.242) than for firms in emerging markets(-1.533). The same pattern is also found for firms split by TURNOVER or RD. 31<br>
(2)The effect of the equity-financing channel is also significantly stronger for firms in the developed markets (coefficient on Q*FF=-2.242) than for firms in emerging markets(-1.533). The same pattern is also found for firms split by TURNOVER or RD. 31<br>
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Rational Corporations-Investment decisions An alternative specification to test H3. Estimate regression (9) for the pooled sample. The coefficient of interest is b3, which is expected to be negative. That is, corporate investment is more sensitive to stock prices for non-financially flexible firms than for financially flexible firms; and the effect of this equity-financing channel should be stronger in countries where the external financing costs are lower, or where shareholders have shorter horizons, or for firms whose assets are more difficult to value. 32<br>
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Rational Corporations-Investment decisions (1) Table 8 (Panel B). In all specifications, the coefficient on Q*FF*COUNTRY is negative with a value ranging from -1.035 to -1.693 and is highly significant at the1%level.
(2)The findings are consistent with the argument that managers of equity-dependent firms will invest more in response to an increase in their stock price when the associated costs of raising external equity are lower. More developed institutions allow managers to exploit the mispricing in stock prices. 33<br>
(2)The findings are consistent with the argument that managers of equity-dependent firms will invest more in response to an increase in their stock price when the associated costs of raising external equity are lower. More developed institutions allow managers to exploit the mispricing in stock prices. 33<br>
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Managerial biases-Financial decisions Capital structure
Overconfidence and excessive optimism lead to underestimation of risks. Biased managers underestimate the probability of financial distress and overestimate the use of tax shield. Hence, biased managers tend to use more debt than equity.
Heaton(2002): The biased manager, acting in the best interest of current shareholders, is averse to issue new equity. He is also likely to see available debt financing as offered at a too 34<br>
Overconfidence and excessive optimism lead to underestimation of risks. Biased managers underestimate the probability of financial distress and overestimate the use of tax shield. Hence, biased managers tend to use more debt than equity.
Heaton(2002): The biased manager, acting in the best interest of current shareholders, is averse to issue new equity. He is also likely to see available debt financing as offered at a too 34<br>
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Managerial biases-Financial decisions high a cost. As a result, the manager exhibits a standard pecking-order preference.
Equity issues
Overconfident and excessively optimistic managers generally use new equity only as a last resort. When they eventually decide to do so, reference dependence plays a prominent role in their decisions about the timing and pricing of equity issue. 35<br>
Equity issues
Overconfident and excessively optimistic managers generally use new equity only as a last resort. When they eventually decide to do so, reference dependence plays a prominent role in their decisions about the timing and pricing of equity issue. 35<br>
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Managerial biases-Investment decisions The distortion of corporate investment
There is evidence that overconfidence and excessive optimism affect business investment, generally leading to overinvestment. However, under special circumstances, overconfidence might also be considered beneficial as it allows to overcome risk aversion and to take up some valuable projects that otherwise would be rejected (startups, innovative R&D). 36<br>
There is evidence that overconfidence and excessive optimism affect business investment, generally leading to overinvestment. However, under special circumstances, overconfidence might also be considered beneficial as it allows to overcome risk aversion and to take up some valuable projects that otherwise would be rejected (startups, innovative R&D). 36<br>
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Managerial biases-Investment decisions Overconfident managers might sometimes prefer to resign from a project or even underinvest than issue new equity that they considered to be undervalued.
Real Investment
Malmendier and Tate (2005) perform cross-sectional tests of the effect of overconfidence on corporate investment.
A proxy for managerial overconfidence based on executives’ predisposition to voluntarily hold 37<br>
Real Investment
Malmendier and Tate (2005) perform cross-sectional tests of the effect of overconfidence on corporate investment.
A proxy for managerial overconfidence based on executives’ predisposition to voluntarily hold 37<br>
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Managerial biases-Investment decisions in-the-money stock options of their firm.
Using this proxy, Malmendier and Tate find that the sensitivity of investment to cash flow is higher in the case of overconfident managers. It turns out to be highest in equity-dependent firms, that is, those which are constrained in new debt raising.
In other words, overconfident executives generally tend to invest more conditional on available cash flows. 38<br>
Using this proxy, Malmendier and Tate find that the sensitivity of investment to cash flow is higher in the case of overconfident managers. It turns out to be highest in equity-dependent firms, that is, those which are constrained in new debt raising.
In other words, overconfident executives generally tend to invest more conditional on available cash flows. 38<br>