1. Behavioral Corporate Finance (I)

2. Outline Rational Corporations in Irrational Markets
Financial Decisions: Equity offerings, Buybacks, Debt issues, and Dividend policy
Investment Decisions: Real investment

3. Rational Corporations-Financial decisions
In chapter 7, it is assumed that corporate managers behave in a fully rational manner and attempt to take advantage of investors’ irrationality and temporary market anomalies.
Financial Decision
Financial decisions of rational managers in the irrational world 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.

4. Rational Corporations-Financial decisions
Equity Offerings
1. IPO
Starting with Ibbotson and Jaffe (1975), a number of studies have demonstrated that IPOs tend to cluster both in time and in sectors.
Rational explanation: IPO clustering could be potentially due to the clustering of real investment opportunities.
However, empirical evidence suggests that the connection to real investment is weak.

5. Rational Corporations-Financial decisions
Behavioral explanation: Decisions on equity issue seem to be driven mainly by temporary overvaluation and market timing attempts.
The IPO market timing hypothesis is also supported by the evidence of poor post-IPO performance both in terms of operational results (Jain and Kini, 1994; Mikkelson et al., 1997; Pagano et al., 1998), as well as negative abnormal long-term post-IPO stock returns (Ritter, 1991; Loughran and Ritter, 1995).

6. Rational Corporations-Financial decisions
2. SEOs (seasoned equity offerings)
Similarly, seasoned equity offerings (SEOs) also tend to be driven by temporary market valuation. The market timing and overvaluation hypothesis for SEOs are also supported by poor post-SEO returns (Loughran and Ritter, 1995; Spiess and Affleck- Graves, 1995; Lee, 1997; Ritter, 2003).
Buybacks
In literature, the possible reasons behind buybacks include the following ones. Among which temporary undervaluation seems to be a strong motive.

7. Rational Corporations-Financial decisions
A number of studies carried out on the US data found positive long-term excess returns following buybacks (Dann, 1981; Lakonishok and Vermaelen, 1990; Ikenberry et al., 1995).
Market Overreaction. Peyer and Varmaelen (2009) observe that stocks experience the most significant positive long-run excess returns if the repurchase is triggered by a severe stock-price decline during the previous six months. They argue that this is driven mainly by the market overreacting to bad news publicly available prior to the repurchase, rather than being a result of positive insider information held by the management.

8. Rational Corporations-Financial decisions
Inside information of Managers. Babenko, Tserlukevich, and Vedrashko (2012) find a positive relation between insider purchases prior to buyback announcements and post-announcement short-term and long-term returns.
Managerial manipulation. Gong et al. (2008) find that both post-repurchase abnormal returns and reported improvements in operating performance are driven by the management of pre-repurchase downward earnings rather than genuine growth in profitability.

9. Rational Corporations-Financial decisions
Rational explanations include survivorship bias, the risk-change hypothesis and the liquidity hypothesis.
Debt issue
Market timing of debt issuances is related to two general aspects—a decision to issue new debt when its cost is unusually low and a choice between issuing short- and long-term debts.
Survey evidence offers support for market timing being a factor in debt issuance decisions.
Besides, the yield curve influences the maturity of new debt.

10. Rational Corporations-Financial decisions
Guedes and Opler (1996) confirm the survey responses with respect to maturity timing. In their sample consisting of 7,369 debt issues in the United States between 1982 and 1993, debt maturity shows a strong negative relation to the difference between long and short-term bond yields (term spread).
Similar results in aggregate data are documented by 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.

11. Rational Corporations-Financial decisions
Dividend Policy
There is common agreement on some empirical facts about dividends.
1. Fama and French (2001) document that the proportion of dividend-paying firms has been declining since 1960s.
2. Dividends are primarily paid by large and well- established firms with low idiosyncratic risk and relatively lower market risk.
3. Stock prices react positively to dividend initiation and negatively to announcements of dividend omissions. The market reaction is, however, asymmetric, negative reaction to omissions being much stronger (Michaely et al., 1995).

12. Rational Corporations-Financial decisions
As the market reaction to dividend announcements is asymmetric, managers are cautious about initiating or increasing dividend payments unless they are convinced that the firm will be able to maintain the payout policy. They also tend to smooth the payments over time.
In the result, dividend volatility is far lower than the volatility of earnings and of course lower than the volatility of stock prices (LeRoy and Porter, 1981; Shiller, 1981; Campbell and Shiller, 1988).

13. Rational Corporations-Financial decisions
The catering theory of dividend proposed by Baker and Wurgler (2004a) might 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.

14. Rational Corporations-Financial decisions
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.
They also find that when the rate of dividend initiation increases, the future stock returns from the portfolio of payers are lower than those from the portfolio of non-payers.

15. Rational Corporations-Financial decisions
Baker and Wurgler see the dividend premium as a reflection of investor sentiment for “risky” non- paying growth firms versus “safe” dividend payers, since it falls in growth stock bubbles and rises in crashes. Fuller and Goldstein (2011) show explicitly that payers outperform in market downturns.

16. Rational Corporations-Investment decisions
Real investment
There are several ways in which irrational investor sentiment may influence decisions of rational managers about real investment.
1. Stock and debt markets affect investment through their influence on the cost of funds.
2. When managers make their investment decisions, they often cater to investors’ beliefs and temporary preferences.

17. Rational Corporations-Investment decisions
The empirical evidence on the direct link between stock prices and investment is mixed.
1. One approach controls for fundamentals and looking for a residual effect of stock prices.
Blanchard, Rhee, and Summers (1993) find that non-fundamental residuals of stock price changes have little predictive power for the level of investment. On the other hand, Galeotti and Schiantarelli (1994) document that both fundamental and non-fundamental parts of stock price changes have significant effects on firms’ level of investment.

18. Rational Corporations-Investment decisions
2. The other approach uses various proxies for mispricing and then examine the relations between these proxies and investment.
Polk and Sapienza (2009) use discretionary accruals to identify mispricing. Firms with high discretionary accruals have subsequently relatively low 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.

19. Rational Corporations-Investment decisions
Baker and Wurgler (2007) propose the sentiment index as a proxy for misvaluation. McLean and Zhao (2013) use that measure and show that investor sentiment has a significant impact on firms’ investment decisions.
The relation between internal cash flow and investment declines with the growth of sentiment.
When the sentiment is low, more projects are forgone due to financing constraints. If managers are careful to select the few most profitable projects, then the average return on investment is high.

20. Rational Corporations-Investment decisions
On the other hand, firms tend to overinvest in high sentiment states, either because they cater to investors’ expectations, or because easy and cheap access to funding encourages acceptance of projects of lower quality. As a result, stock returns following investment made in high sentiment states are significantly lower than stock returns on investment made in low sentiment periods.
Stein (1996) and Baker, Stein, and Wurgler (2003) show that mispricing driven investment is most sensitive in equity-dependent firms.