1. Behavioral Foundations
Chapter 1
Behavioral Foundations
Behavioral Corporate Finance
by Hersh Shefrin

2. Traditional treatment of corporate financial decisions
Firms raise funds by borrowing on lines of credit, issuing commercial paper, selling corporate bonds, issuing new equity, and generating operating cash flows.
Firms use funds when they undertake projects, acquire fixed assets, build inventory, pay dividents, engage in mergers and acquisitions, and deal with legal and regulatory issues.

3. Cont…
The traditional value-maximizing approach is based on discounted cash flow (DCF) analysis.
Virtually all the decisions just mentioned involve risk.
Risk enters into the analysis through the discount rate that is applied to the expected cash flows.

4. Cont…
According to DCF analysis, projects should be undertaken if the present value of the expected future value cash flows exceeds the initial investment required.

5. Behavioral Treatment Of Corporate Financial Decisions
The traditional material taught in corporate finance courses offers powerful techniques that in theiry help managers to make value-maximizing decisions for their firms.
Yet, in practice, Psychological pitfall hamper managers in applying these techniques correctly.

6. Cont…
Because psychologically induced mistakes can be, and often are, very expensive, studying behavioral corporate finance is vital.
Like agency conflicts, behavioral phenomena also cause managers to take actions that are detrimental to the interests of shareholders.

7. Cont…
Behavioral costs are the result of managers’ mistakes, not the result of managers having different interests from investors.
Remedies for agency conflicts tend to emphasize the manipulation of incentives.

8. Cont…
Remedies for behavioral pitfalls tend to emphasize training and process.

9. Illustrative Example
Sun is known producing servers, Computers that perform complex functions such as transmitting Web pages over the Internet.
Sun’s chief executive officers (CEO) Scott McNealy.

10. Biases Bias: A predisposition toward error.
This section discusses four particular biases
Excessive Optimism
Overconfidence
Confirmation Bias
Illusion Of Control.

11. Excessive optimism
People overestimate how frequently they will experience favorable outcomes and underestimate how frequently they will experience unfavorable outcomes.

12. Delayed Cost Cutting and Value Loss
Excessive optimism lead him to delay cost-cutting measures, which resulted in steep losses for Sun.
The general evidence suggests that people who report that economic conditions will improve are twice as optimistic as those who report that economic conditions will either stay the same or get worse.

13. Excessively optimistic Sun Stockholders
During the stock market bubble between January 1997 and June 2000, irrational exuberance drove up the prices of both the S&P 500 and Sun’s stock.
No firm the size of sun has historically merited a price-to-earnings ratio (P/E) over 100. In March 2000, at the height of the bubble, Sun’s P/E reached 119.

14. Cont…
Blindly trusting market prices can lead even the best-intentioned managers to make faulty decisions about investment policy, financing, and acquisitions.

15. Overconfidence
People make mistakes more frequently than they believe and view themselves as better than average.

16. Cont…
Some use the term overconfident to mean optimistic. Overconfidence and excessive optimism often go hand in hand, but are not the same.
The point is that overconfident managers are overly convinced that their views are correct.

17. Overconfidence about Ability
Overconfident people can certainly be smart, just not quite as smart as they think they are. More-over, people can learn to be overconfident, as a result of past successes.
Overconfident managers tend to make poor decisions about both investments and mergers and acquisitions, especially if their firms are cash-rich.

18. Cont…
Sun’s increased spending on research and development in 2000 and its acquisition of Cobalt are cases in point.

19. Overconfidence about Knowledge
Was Scott McNealy overconfident about his knowledge of U.S business cycles?
He was certainly confident that the 2001 recession would be sharp-edged, by which he meant that it would feature a sharp downturn followed by a sharp upturn.

20. Cont…
There in no pattern suggesting that recessions were becoming increasingly sharp edged. Scott McNealy was simply overconfident

21. Confirmation Bias
People attach too much importance to information that supports their views relative to information that runs counter to their views.

22. Turning a Blind Eye
In late 2000, executives at Sun learned that the revenues of industry leaders Cisco Systems were declining dramatically and began to suggest that a cost-cutting program be put in place at Sun.

23. Cont…
Despite the recommendations of his upper-level executives, McNealy refused to approve any cost cutting at Sun. Scott McNealy exhibited confirmation bias, which led him to make that dramatically reduced the value of his firm.
Illusion of control: People overestimate the extend to which they can control events.

24. Not Made Here
The Business Week article describes a decision that Sun’s managers had to make in 1997: whether to use their own microchips for Sun servers or to use Intel’s chips.
In 1997, Sun could purchase Intel’s chips for 30 percent less than what it cost to produce its own comparable chips.

25. Cont…
Scott McNealy felt that Sun’s chips design group exerted enough control to close the gap
McNealy ordered that Sun would not feature “Intel Inside”.
Intel chips were twice as fast as those produced by Sun.

26. Cont…
McNealy describes his decision about using Intel chips as one of his biggest regrets.

27. Heuristics Heuristics is a rule of thumb used to make a decision.
These biases are known as:
Representativeness
Availability
Anchoring And Adjustment
Affect.

28. Representativeness
People make judgments based on stereotypic thinking, asking how representative an object or idea is for the class to which they belong.

29. The Internet Represents the Overall Economy
Internet firms have a short history.
The Business Week article reported that Scott McNealy believed that the Internet had fundamentally changed the U.S economy and that the Internet was critical to great many firms.

30. Cont…
Representativeness-based thinking would have lead Scott McNealy to conclude that the U.S business cycle pattern would be sharp-edged instead of a rolling wave.

31. Availability
Availability: People overweight information that is readily available and intuitive relative to information that is less salient and more abstract, thereby biasing judgments.

32. Out of Sight, Out of Mind
Sun played a principal role in a large suit against rival firm Microsoft that received national intention.
The dispute had extended out several years and had become quite personal between Scott McNealy and Microsoft’s founder Bill Gates.

33. Cont…
Asking for low-end servers in order to cut costs during the downturn.
With Microsoft on his mind, McNealy paid little attention to customers’ requests.

34. Anchoring and Adjustment
Anchoring and Adjustment: People form an estimate by beginning with an initial number and adjusting to reflect new information or circumstances. However, they tend to make insufficient adjustments relative to that number, thereby leading to anchoring bias.

35. Anchored to Growth
During its most successful period, the turn of the century, Sun’s earnings growth rate reached 50 percent per quarter, faster than competitors Microsoft, Intel, and Dell.
That rate was not sustainable on a permanent basis.

36. Cont…
If Sun’s executives became anchored on the 50 percent, then even if they adjusted their forecasts of future growth downwards, they would be psychologically disposed to adjust insufficiently.

37. Affect Heuristic Affect: An emotional feeling
Affect heuristic: Basing decisions primarily on intuition, instinct, and gut feeling.

38. Acquisitions That Feel Right but Destroy Value
Intuition is based on affect.
Intuition is important, make no mistake about it. Experience is valuable, and firms pay for experienced managers.
The emotions that the managers feel are a manifestation of their minds making associations with the memories of past experiences. However, experience is not a substitute for careful analysis.

39. Framing Effects Frame: Synonymous for description.
Framing Effect: A person’s decisions are influenced by the manner in which the setting for the decision is described.
Prospect Theory: A general psychological approach that describes the way people make choices among risky alternatives.

40. Cont…
Loss Aversion: Psychologically, people experience a loss more acutely than a gain of the same magnitude.
Narrow Framing: Treating a repeated risk as if it were a one-shot deal.

41. Loss Aversion Can Cause Dept Aversion
Traditional textbooks in corporate finance teach that dept can be used to shield investors from corporate taxes.
Many firms appear to take on less dept than textbook theory suggests.

42. Cont…
Merck’s total dept has typically been low, below 20 percent of its assets during the 20-year period 1983 through These ratios are based on book values, meaning Merck’s financial statements.
Financial textbooks suggest that decisions about dept be made using market values rather than dept values.

43. Loss Aversion
Merck’s managers chose a dept policy that was overly conservative because they were loss averse.
Loss aversion leads managers to be reluctant to issue dept, even when issuing more dept would produce positive financing side effects for shareholders.

44. Cont…
Psychologically, the potential losses stemming from financial distress can loom larger than the potential gains stemming from tax shields.

45. Aversion to a Sure Loss
Aversion to a sure loss: People choose to accept an actuarially unfair risk in an attempt to avoid a sure loss.

46. Debiasing
Debiasing: Reducing susceptibility to biases and framing effects.
Psychologists have repeatedly demonstrated that recognizing our errors and biases does not lead us to change our behavior automatically.
The psychology that underlies errors and biases is remarkably resistant to change.

47. Cont…
That is not to say that people cannot learn to avoid mistakes. People can learn.
People learn slowly, and the task of debiasing requires great effort.

48. Cont…
Debiasing is more difficult in some situations than in others. Situations where people receive quick, clear feedback about the results of their actions are more conductive to debiasing efforts than situations where the feedback is slow, and outcomes are influenced by many factors.

49. The End