BEHAVIOURAL CORPORATE FINANCE

Introduction
Traditional approach to corporate finance embodied by value - based
management is based on three concepts.
A] Rational behaviour, [b] The capital asset principal model [CAPM], [c]
efficient markets.
 The proponents of behavioural finance agree that psychological forces interfere
with all the three components of traditional paradigm.
They maintain that psychological phenomena prevent decision makers from
acting in a rational manner, that security risk premiums are not fully determined
by security betas, and that market prices are regularly at odds with fundamental
values.
There are two impediments to the process of value maximization;
1. Internal to the firm, referred to as the impediment behavioural cost. These are
costs or loss in value associated with errors that managers make because of
cognitive imperfections and emotional influences.
2. External to the firm. Impediment behavioural errors by analysts and investors.
These errors can create a wedge between fundamental values and market prices
1. BEHAVIOURAL OBSTACLES THAT ARE INTERNAL TO THE FIRM
Academics and practitioners involved in issues of value- based
management tend to focus exclusively an agency costs, which arise when
agents [in the case, managers] are in conflict with the interests of the
principals they have been engaged to severe [the owners or the stock
holders]. Mechanisms that encourage agents to act in accordance with
principals interests are said to be incentives compatible bonuses, shares
etc. proponents of value-based management emphasize that with properly
designed incentives managers will maximize the value of firms for which
they work. But behavioural costs can be quite large and cannot be
addressed through incentives alone. There are limits to what incentives can
achieve. If employees have a distorted view of what is in their own self-
interest or if they have a mistaken view of what actions they need to take
in order to maximize their self-interests, then incentives compatibility,
although necessary for value maximization will not be sufficient.
 The effect of group behaviour on decision making
Researchers have found that groups often amplify individual errors. Most major
corporate decisions are made in group setting. In this respect, research suggests
that senior managers working in committees are even more prone to escalate
their commitments to projects whose outcomes may have become questionable.
A study of the group amplification impact on project termination decision
provided two descriptions of a particular project both individual decision makers
and to groups. Although the future prospects for the project were not attractive,
one description of the project featured sunk costs while the second did not.Only
29 percent of individual decisions makers who received the description without
the sunk cost recommended that the project be funded. However, when the
description included information about a sunk cost, 69 percent of the individual
decision makers recommended that the project be funded. Only 26 percent of
the groups recommended funding when no sunk cost was described. However, 86
percent recommended funding when the description included sunk cost. In other
words, the behavioural error is actually amplified when the decision is made by a
group rather than by an individual.
 2. BEHAVIOURAL OBSTACLES THAT ARE EXTERNAL TO THE FIRM
When it comes to behavioural phenomena that are external to the
firm corporate managers face a different set of challenges .Traditional
textbooks in corporate finance teach managers how to make rational
decisions about capital budgeting and capital structures under the
premises that investors and analysts also behave rationally . However
investors and analysts are not always rational
For example, Brealey and Myers warn readers not to mistake earnings
growth for value creation,
Pointing out that a firm that grows its earning can also be destroying
its value.
 Market efficiency and behaviour
In the traditional approach to corporate finance, managers are urged to act as if
markets are efficient.
Analysts, Brealey and Myers for example suggested a principle that markets have
no memory- that a stocks past price behaviour is no indication of its future
price behaviour. Yet they point out that managers appear to act as if markets do
have memory because managers like to issue new stocks after the price of their
firms shares has risen and tat by the same token managers appear to be
reluctant to issue new students after the price of their firms shares has risen, and
that by the same token, managers appear to be reluctant to issue new shares
after the price of their firms shares has declined.
 Researchers argue that as a general matter, IPOs feature three behavioural
phenomena that involve market memory and that are inconsistent with the
efficient market hypothesis. The three phenomena are:
1] Hot issue markets .This is a period when demand for shares is very high and
may create an impression that the market rate the shares of the company highly.
It may be misleading for the managers to make decisions based on this to float
more shares.
2] Initial under-pricing. As observed by the researchers, sales in hot issues
market rise within a short period and may trade at a higher price at the end of
that period (day).This may suggest a temporary under-pricing
3] Long term underperformance. Researchers have found out that the IPO price
may be high and then start declining to the lowest in the long- run.
While the efficient market principle may take the IPO price to project the future
share price and capitalization, the researchers advice otherwise believing that the
markets have no memory.
 Capital budgeting and Capital structure
Capital structure is the combination of debt and equity that obtain the stated managerial
goal i.e. the maximization of the firms market value. Capital budgeting is the allocation
of capital.
Managers are concerned with how to set project hurdle rates appropriately for them to
achieve the goals of the firm. In traditional corporate finance, the capital asset pricing
model [CAPM] provides the theoretical basis for deriving the appropriate hurdle rates to
be used in capital budgeting. However, the traditional approach rests on the premises
that prices are efficient.
There are two main elements in approaching the problems of how managers can arrive
at appropriate discount rates when prices are inefficient but managers are fully rational
[that is , managers do not commit behaviourally induced errors]
1] Time horizon over which managers seek to maximise values.
2] Interactions between capital budgeting and capital structure in the face of inefficient
prices.
When investors and analysts are unduly optimistic about a firms future prospects and as
a result bid up the price of its stock, the attendant mispricing causes the firms future
expected returns to be abnormally low. Managers might then want to consider either the
issuance of new equity or the funding of new projects.
In the simplest case the firm is unconcerned about the correct mix of debt and equity,
and the market does not immediately react to a new equity issue by drastically biding
down the prices of its shares. In this case, the appropriate course of action is for the firm
to issue new, overpriced shares thereby transferring wealth from new shareholders to
old shareholders.
 If the firms current shareholders were rational and informed, then they would not plan
to hold overpriced stock long- term. Instead, they would sell it before its price dropped
back towards fundamental value. In this case, an argument can be made that the
managers responsibility is to maximize the wealth for the current shareholders by
undertaking projects that will increase the current market value of the firm even at the
expense of long- term value. However, if the firms current shareholders plan to hold
overpriced stock long- term, either because they are irrational, poorly informed, or
constrained from selling short- term, then the manager may well choose to forgo
projects that lead to a short term increase in value.
In this case, the manager may choose to maximise long- term value, which may be
chosen for typical situation.
Behavioural finance offers guidelines for value maximising managers when the stocks of
their firms are mispriced.
1] If there are no germane spill over effects from project selection decisions onto capital
structure, and managers seek to maximize long- term value, then the appropriate hurdle
to use is the CAPM-based rate. And the managers should only adjust the hurdle rate to
reflect the level of project risk.
2] If project selection decisions do have germane spill over effect onto capital structure,
then the value maximising managers will need to adjust their project hurdle rates to
reflect the degree to which the equity of their firm is mispriced in the market. Otherwise,
they might use cash to fund a project when they could create value by using cash to
repurchase undervalued shares.
 Considering the first guideline imagine, imagine that investors are irrationally exuberant
about the value potential of the firms project and in consequence bid up the price of its
stock to the point that it becomes overvalued. A rational manager expects that in the
long- run the firms stock price will revert to fundamental value thereby causing the
current objective expected return to be low. Therefore a manager who decides to adopt
the project for short- term advantage implicitly uses an objective hurdle rate that is low.
In this case the manager accepts the project that is expected to be uneconomical in the
long- run but whose adoption leads to the stock price to rise in the short run. In contrast,
a rational manager with a call of maximizing value for long- term investors reflects
projects that only have a short- term advantage and implicitly uses a higher hurdle rate.
Indeed a manager who is guided by consideration of long- term value is effectively
advised to use the traditional CAPM hurdle rates. This is because in the long- term, prices
refer to fundamental value. Hence the best forecast of long- run returns is based on the
CAPM beta. The CAPM rate is the appropriate hurdle rate whenever capital budgeting
decisions and financing structure are independent.
 Considering the second guideline, when capital budgeting decisions
and financing decisions are linked, the appropriate hurdle rate is
effectively a weighted average of the CAPM rate and a behavioural
based rate that reflects the degree of mispricing in the market, with
the weights determined by the firms capital structure. For example, if
the firms debt-to-equity ratio is 1.0, the CAPM-derived rate is ten
percent and mispricing leads the objectives expected return on the
firms shares to be 20 per cent, then the appropriate hurdle rate is 15
per cent midway between 10 percent and 20 percent [because the
debt to capital and equity to capital ratios are each 50 per cent).
 References

Adams, Renee, Heitor Almeida, and Daniel Ferreira, 2004, Powerful CEOs
and their impact on corporate performance, Review of Financial Studies,
forthcoming.

Aghion, Philippe, and Jeremy Stein, 2004, Growth vs. margins: Business-
cycle implications of giving the stock market what it wants, Harvard
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Andrade, Gregor, Mark L. Mitchell, and Erik Stafford, 2001, New evidence
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120.