BehavioralCorporateFinance:ACurrentSurvey

ForthcominginHandbookoftheEconomicsofFinance:Volume2GeorgeM.Constantinides,MiltonHarris,andReneM.Stulz,Eds.

ElsevierPress,2012

MalcolmBakerHarvardBusinessSchoolandNBER

BakerHall261Boston,MA02163617‐495‐6566

mbaker@hbs.edu

JeffreyWurglerNYUSternSchoolofBusinessandNBER

44West4thSt,Suite9‐190NewYork,NY10012

212‐998‐0367jwurgler@stern.nyu.edu

Abstract:We survey the theory and evidence of behavioral corporate finance, which generallytakesoneoftwoapproaches.Themarkettimingandcateringapproachviewsmanagerialfinancingandinvestmentdecisionsasrationalmanagerialresponsestosecuritiesmispricing.Themanagerialbiasesapproachstudiesthedirecteffectsofmanagers’biasesandnonstandardpreferencesontheirdecisions.Wereviewrelevantpsychology,economictheoryandpredictions,empiricalchallenges,empiricalevidence,newdirectionssuchasbehavioralsignaling,andopenquestions.

Keywords: Behavioral, Corporate Finance, Sentiment, Catering, Market Timing, Irrational, Bias,Overconfidence,Optimism,Signaling

JELCodes:G14,G30,G31,G32,G34,G35

ThissurveyupdatesandextendsasurveycoauthoredwithRickRubackthatwaspublishedintheHandbookinCorporateFinance:EmpiricalCorporateFinance,editedbyEspenEckbo,in2007.Wethankhimforhismanycontributionsthatcarriedovertothisversion,andwethankMiltHarrisforextensiveandhelpfulcomments.BakergratefullyacknowledgesfinancialsupportfromtheDivisionofResearchoftheHarvardBusinessSchool.

Table of Contents 

1. Introduction...................................................................................................................................1

2. Markettimingandcatering......................................................................................................52.1. Backgroundoninvestorbehaviorandmarketinefficiency.................................................52.1.1. Limitedarbitrage............................................................................................................................................62.1.2. Categorizationandinvestorsentiment.................................................................................................82.1.3. Prospecttheory,referencepoints,lossaversion,andanchoring...............................................92.1.4. Smartmanagers............................................................................................................................................11

2.2. Theoreticalframework:Rationalmanagersinirrationalmarkets.................................122.3. Empiricalchallenges.........................................................................................................................182.4. Investmentpolicy...............................................................................................................................222.4.1. Realinvestment.............................................................................................................................................222.4.2. Mergersandacquisitions..........................................................................................................................252.4.3. Diversificationandfocus...........................................................................................................................27

2.5. Financialpolicy..................................................................................................................................282.5.1. Equityissues...................................................................................................................................................282.5.2. Repurchases....................................................................................................................................................332.5.3. Debtissues.......................................................................................................................................................342.5.4. Cross‐borderissues.....................................................................................................................................372.5.5. Financialintermediation...........................................................................................................................372.5.6. Capitalstructure...........................................................................................................................................41

2.6. Othercorporatedecisions.............................................................................................................432.6.1. Dividends.........................................................................................................................................................432.6.2. Earningsmanagement................................................................................................................................452.6.3. Firmnames......................................................................................................................................................472.6.4. Nominalshareprices..................................................................................................................................482.6.5. Executivecompensation............................................................................................................................49

3. ManagerialBiases......................................................................................................................503.1. Backgroundonmanagerialbehavior.........................................................................................503.1.1. Limitedgovernance.....................................................................................................................................503.1.2. Boundedrationality.....................................................................................................................................513.1.3. Optimism,overconfidenceandhubris.................................................................................................523.1.4. Moreonreferencedependence..............................................................................................................53

3.2. Theoreticalframework...................................................................................................................543.3. Empiricalchallenges........................................................................................................................573.4. Investmentpolicy..............................................................................................................................583.4.1. Realinvestment.............................................................................................................................................583.4.2. Mergersandacquisitions..........................................................................................................................62

3.5. Financialpolicy..................................................................................................................................653.5.1. Equityissues...................................................................................................................................................653.5.2. IPOprices.........................................................................................................................................................66

3.5.3. Raisingdebt....................................................................................................................................................673.5.4. Capitalstructure...........................................................................................................................................683.5.5. Contractingandexecutivecompensation..........................................................................................69

4. BehavioralSignaling.................................................................................................................714.1. TheoreticalFramework...................................................................................................................724.2. Applications........................................................................................................................................774.2.1 Dividends.........................................................................................................................................................774.2.2. Otherapplications........................................................................................................................................78

5. Conclusion.....................................................................................................................................80

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1.   Introduction 

Corporatefinanceaimstoexplainthefinancialcontractsandtherealinvestmentbehavior

thatemergefromtheinteractionofmanagersandinvestors.Acompleteexplanationoffinancing

andinvestmentpatternsthereforerequiresacorrectunderstandingofthebeliefsandpreferences

ofthesetwosetsofagents.Themajorityofresearchincorporatefinancemakesbroadassumptions

thatthesebeliefsandpreferencesarefullyrational.Agentsaresupposedtodevelopunbiased

forecastsaboutfutureeventsandusethesetomakedecisionsthatbestservetheirowninterests.

Asapracticalmatter,thismeansthatmanagerscantakeforgrantedthatcapitalmarketsare

efficient,withpricesrationallyreflectingpublicinformationaboutfundamentalvalues.Likewise,

investorscantakeforgrantedthatmanagerswillactintheirself‐interest,rationallyrespondingto

incentivesshapedbycompensationcontracts,themarketforcorporatecontrol,andother

governancemechanisms.

Researchinbehavioralcorporatefinancereplacesthetraditionalrationalityassumptions

withbehavioralfoundationsthataremoreevidence‐driven.Thefieldisnolongerapurely

academicpursuit,asbehavioralcorporatefinanceisincreasinglythebasisofdiscussionsin

mainstreamtextbooks.1Wedividetheliteratureintotwobroadgroupsandorganizethesurvey

accordingly.Roughlyspeaking,thefirstapproachemphasizestheeffectofinvestorbehaviorthatis

lessthanfullyrational.Thesecondconsidersmanagerialbehaviorthatislessthanfullyrational.

Foreachlineofresearch,wereviewthebasictheoreticalframeworks,themainempirical

challenges,andtheevidence.Ofcourse,inpractice,multiplechannelsofirrationalitymayoperate

atthesametime;ourtaxonomyismeanttofitthebulkoftheexistingliterature.

1ForexampleseeDamodaran(2011),Shefrin(2006),Shefrin(2008),andWelch(2009).

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The“markettimingandcateringapproach”assumesthatarbitrageinsecuritiesmarketsis

imperfect,andasaresultpricescanbetoohighortoolow.Wereviewthemarketinefficiency

literatureinsofarasitisrelevant.Rationalmanagersareassumedtoperceivethesemispricings,

andtomakedecisionsthatexploitorfurtherencouragemispricing.Whiletheirdecisionsmay

maximizetheshort‐runvalueofthefirm,theymayalsoresultinlowerlong‐runvaluesasprices

correcttofundamentals.Inthesimpletheoreticalframeworkweoutline,managersbalancethree

objectives:fundamentalvalue,catering,andmarkettiming.Maximizingfundamentalvaluehasthe

usualingredients.Cateringreferstoanyactionsintendedtoboostsharepricesabovefundamental

value.Markettimingreferstofinancingdecisionsintendedtocapitalizeontemporarymispricings,

generallybyissuingovervaluedsecuritiesandrepurchasingundervaluedones.

Empiricaltestsoftheirrationalinvestorsmodelfacethechallengeofmeasuringmispricing.

Wediscusshowthisissuehasbeentackled.Afewpapersusecleverapproachesthatcanidentify

mispricingfairlyconvincingly,butinmanycasesambiguitiesremain.Overall,despitesome

unresolvedquestions,theevidencesuggeststhattheirrationalinvestorsapproachhasa

considerabledegreeofdescriptivepower.Wereviewstudiesoninvestmentbehavior,merger

activity,theclusteringandtimingofcorporatesecurityofferings,capitalstructure,corporatename

changes,nominalshareprices,dividendpolicy,earningsmanagement,andothermanagerial

decisions.Wealsopointoutgapsthatremainbetweenthetheoryandtheevidence.

Thesecondapproachthatwediscussisthe“managerialbiases”approach.Itassumesthat

managershavebehavioralbiases,butretainstherationalityofinvestors,albeitlimitingthe

governancemechanismstheycanemploytoconstrainmanagers.Followingtheemphasesofthe

currentliterature,ourdiscussioncentersonthebiasesofoptimismandoverconfidence.Asimple

modelshowshowthesebiases,inleadingmanagerstobelievetheirfirmsareundervalued,

encourageoverinvestmentfrominternalresources,andapreferenceforinternaltoexternal

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finance,especiallyinternalequity.Wenotethatthepredictionsoftheoptimismandoverconfidence

modelstypicallylookverymuchlikethoseofagencyandasymmetricinformationmodels.

Inthisapproach,themainobstaclesforempiricaltestsincludedistinguishingpredictions

fromstandard,non‐behavioralmodels,aswellasempiricallymeasuringmanagerialbiases.Again,

however,creativesolutionshavebeenproposed.Theeffectsofoptimismandoverconfidencehave

beenempiricallystudiedinthecontextofcorporateandentrepreneurialfinancingandinvestment

decisions,mergeractivity,andthestructureoffinancialcontracts.

Wealsocoveranewerapproachthatwecall“behavioralsignaling.”Thisisaresponsetothe

manysophisticatedsignalingmodelsincorporatefinancetheorythatmaketwoquestionable

assumptions.Theyassumefullrationalityandstandardpreferences;and,theyusethedestruction

offirmvalueasthecrediblesignalingmechanism—thebetterfirmistheonethatdestroysmore

value,anotionrejectedbymanagersinsurveys.Behavioralsignalingmodelsinsteadbasethe

signalingmechanismonsomedistortioninbeliefsorpreferences.Wedescribeamodelof

dividendswhereinvestorsareloss‐averseoverthelevelofdividends,sothatamanagerthat

ratchetsupdividendstodaycansignalthathecanlikelymeetorexceedthatleveltomorrow.

Followingthis,wespeculateaboutothertopicsthatmightbeaddressedwhenasymmetric

informationiscombinedwithnonstandardpreferencesorbiasedexpectations.

Sprinkledthroughoutthesurveyarediscussionsofresearchthatishardtocategorizeinto

justoneparadigm.Forexample,mergersarearrangedbybankersandtwosetsofmanagersand

approvedbyshareholders;behavioralbiasesthataffecttheoutcomearedifficulttoattributetoone

party.Theymaywellbesharedacrossparties.Complicationslikethesesuggestwhythereal

economiclossesassociatedwithbehavioralphenomenaincorporatefinancearehardtoquantify,

althoughsomeevidencesuggeststhattheyareconsiderable.

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Behavioralcorporatefinance,andbehavioralfinancemorebroadly,receivedaboostfrom

thespectacularriseandfallofInternetstocksbetweenthemid‐1990sand2000.Itishardto

explainthisperiod,bothatthelevelofmarketaggregatesandindividualstocksandother

securities,withoutappealingtosomedegreeofinvestorandmanagerialirrationality.

Themorerecentfinancialcrisisismorecomplex,aswediscuss.Themispricingdidnot

involveanewtechnology,butrathermoremundanemortgagefinancemadeopaquethrough

financialinnovationandthecreationofseeminglylow‐riskderivatives.Thebuyerswerenotretail

investors,butbanksandmoneymarketmutualfunds.Mostimportantly,thesystemicallyimportant

banksthatcreatedthesesecuritieshadsomeofthelargestexposures.ItwasasifBankofAmerica

hadheldontoalargefractionoftheInternetstocksthatwereunderwritteninthelate1990s.

Therewereequalpartstraditionalcorporatefinancefrictions,likeagencyproblems,signaling,and

debtoverhang,andbehavioraldistortionsthatledtoboththecreditbubbleandthechallengesof

resettingbankbalancesheets.Theeconomicdamagewasfurthermultipliedbecausebanks

themselvesshoulderedthelosses.

Takingastepback,itisimportanttonotethattheapproachestakeverydifferentviews

abouttheroleandqualityofmanagers,andhaveverydifferentnormativeimplicationsasaresult.

Forexample,whentheprimarysourceofirrationalityisontheinvestorside,asinthemarket

timingandcateringapproachandinourimplementationofbehavioralsignaling,long‐termvalue

maximizationandeconomicefficiencyrequiresinsulatingmanagersfromshort‐termshareprice

pressures.Managersneedtheflexibilitynecessarytomakedecisionsthatmaybeunpopularinthe

marketplace.Thismayimplybenefitsfrominternalcapitalmarkets,barrierstotakeovers,andso

forth—manyoftheinstitutionsthataredisdainedbyanagencyperspective.Ontheotherhand,if

themainsourceofirrationalityismanifestedthroughmanagerialbiases,efficiencyrequires

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reducingdiscretionandobligatingmanagerstorespondtomarketpricesignals—asstandard

agencytheoryandasymmetricinformationmodelswouldhaveit.

Thestarkcontrastbetweenthenormativeimplicationsofdifferentapproachesto

behavioralcorporatefinanceisonereasonwhytheareaisfascinating,andwhymoreworkinthe

areamayleadtoimportantinsights.Ourever‐improvingunderstandingoftheeconomic

implicationsofsocialpsychologyandtheever‐increasingavailabilityofmicrodatawillcontinueto

presentnewresearchopportunities.Inthatvein,weclosethesurveywithsomeopenquestions.

Andatthispointwewouldalsoliketopointthereadertoexcellentrecentsurveysof

individualtopicsinbehavioralcorporatefinance:Ben‐David(2010)ondividendpolicy,Derrien

(2010)onIPOs,Dong(2010)onmergersandacquisitions,GiderandHackbarth(2010)on

financingdecisions,Gervais(2010)oninvestmentdecisions,andMorck(2010)ongovernance.

2.   Market timing and catering 

Themostdevelopedframeworkinbehavioralcorporatefinanceandlongestsectioninthis

surveyinvolvesrationalmanagersinteractingwithirrationalinvestors.

2.1.   Background on investor behavior and market inefficiency 

Therearetwokeybuildingblocksinthemarkettimingandcateringframework.Thefirstis

thatirrationalinvestorsmustinfluencesecuritiesprices.Inotherwords,thatsecuritiesmarketsare

notentirelyinformationallyefficient.Otherwise,itisnotobviousthatmanagerswouldtakemuch

caretopleasesuchinvestors.Forirrationalinvestorstoaffectprices,rationalinvestorsmustbe

limitedintheirabilitytocompeteandarbitrageawaymispricings.Wediscussthelimitedarbitrage

literaturebelowsincethisissuchacriticalassumption.

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Irrationaltraders’biasesmustbesystematic,aswell,orelsetheirowntradingmightsimply

cancelout,leavingarbitrageurswithlittletodoanyway.Wediscussafewwell‐documentedand

robustdeviationsfromstandardutilityandBayesianbeliefsfromthepsychology,economics,and

financeliteratures.Theparticulardeviationsthataremostimmediatelyapplicabletocorporate

financeinvolvecategorizationandreference‐dependentbehavior.Combinedwithlimitedarbitrage,

thesebiasesleadtomarketinefficiencies.2

Thesecondkeybuildingblockofthemarkettimingandcateringviewisthatmanagers

mustbe“smart”inthesenseofbeingabletodistinguishmarketpricesandfundamentalvalue—to

recognizethemispricingsthatirrationalinvestorshavecreated,especiallyinextreme

circumstances.Wereviewseveralreasonswhythisassumptionisplausible.

2.1.1.  Limited arbitrage 

Securitiespricesreflectfundamentalvalueswheninformedinvestorscompeteaggressively

toeliminatemispricings.Classicalfinancetheory,includingtheModigliani‐Millertheorem,holds

thattheywilldosobecausemispricingsbetweentwocompanieswiththesameoperatingcash

flowsbutdifferentcapitalstructures,inasettingofcompleteandfrictionlesssecuritiesmarkets,

presentarbitrageopportunities.Theassumptionofmarketefficiencyhasfordecadespermitted

corporatefinancetheorytodevelopindependentlyofassetpricingtheory.

2Theliteratureonmarketinefficiencyisvast.ItincludesfairlyconvincingevidenceofinefficienciesincludingtheJanuaryeffect;theeffectoftradinghoursonpricevolatility;post‐earnings‐announcementdrift,positiveautocorrelationinquarterlyearningsannouncementeffects,andmoregenerallydelayedreactiontonews;momentum;Siamesetwinsecuritiesthathaveidenticalcashflowsbuttradeatdifferentprices;negative“stub”values;closed‐endfundpricingpatterns;bubblesandcrashesingrowthstocks;relatedevidenceofmispricinginoptions,bond,andforeignexchangemarkets;andinterestingnewpatternseveryyear.Thislistexcludesanomaliesrelatedtosecuritiesissuancethatwediscusslater.SeeBarberisandThaler(2003)andShleifer(2000)forclassicsurveysofthebehavioralfinanceandassetpricingliteraturemorebroadly.

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Theliteratureonlimitedarbitrage,however,concludesthatsecuritiesmarketmispricings

oftendonotpresentopportunitiesfortruearbitrage.Asaresult,mispricingscanexistandpersist.

Asjustoneexample,thefactthatstocksaddedtomarketindexesseetheirpricesjumphasbeen

viewedasprimafacieproofoflimitstoarbitrageinthestockmarket(Shleifer(1986)andHarris

andGurel(1986)).Adeeperstudyofspecificarbitragecostsandrisksisuseful,however,because

whenthesecostsaremeasurable,theymayleadtoempiricalstrategiesformeasuringmispricing,

aswediscusslater.

EarlycontributionstotheliteratureincludeMiller(1977),whopointsoutthatshort‐sale

constraintscanleadtosecuritiesbeingoverpriced.DeLong,Shleifer,Summers,andWaldmann

(1990)highlighttheriskthatirrationaltraderspushpricesfurtherawayfromfundamentalsaftera

would‐bearbitrageurtakesaposition.ShleiferandVishny(1997)pointoutthatprofessional

investmentmanagers,theenforcersofmarketefficiencyinclassicaltheory,infacthaveaspecial

incentivetoavoidthisnoisetraderrisk:intherealisticcasewhereinvestorscannotdistinguish

betweenreturnsearnedbyluckandskill,theymayassumetheworstandwithdrawfundswhen

facedwithlosses.

Thereareanumberofadditionalcostsandrisksofarbitrage.Animportantoneis

fundamentalrisk,whichmakesrelative‐valuearbitrageriskybecauseamispricedsecurity’scash

flowsarenotspannedbythoseofotherassets(Pontiff(1996)andWurglerandZhuravskaya

(2002)).Liquidityriskariseswheneveryonewantstosellatthesametime(AcharyaandPedersen

(2004)).Finally,real‐worldinvestorsmustbearsimpletransactioncosts,searchcosts,and

information‐gatheringcoststoexploitmispricings.

Theideathatsecuritiespricesareaffectedbymorethanjustfundamentalshasbeen

examinedinmarketsfrompennystockstogovernmentbonds.Krishnamurthy(2002)findsthaton‐

the‐runTreasuryissuestradeatapremiumtootherbonds,whileDuffee(1996)connectsthe

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supplyofindividualbillstonon‐fundamentalvariationintheTreasuryyieldcurve.Atahigherlevel

ofaggregation,Hu,Pan,andWang(2010)useanomalouspatternsintheshapeoftheyieldcurveto

quantifyhowwellcapitalizedoreffectiveisbondmarketarbitrage.Atthebroadestlevel,

GreenwoodandVayanos(2010)arguethattheoverallshapeoftheyieldcurveiscausallyaffected

bythematuritystructureofgovernmentdebtissues.Thisassertionimpliesmispricingsoffar

greatersizethanthoseevidencedbyrelative‐valuedistortionswithintheyieldcurve—large

enough,perhaps,tocatchtheattentionofmanagers,ortheirinvestmentbankers,andaffect

corporatematuritystructurechoices.

Insummary,abodyoftheoryandevidenceindicatesthatcapitalmarketshavealimited

capacitytoabsorbdemandshocksthatareindependentoffundamentalnews.Thenexttaskisto

understandtheinvestorpsychologythatisbehindsomeofthesedemandshocks.

2.1.2.  Categorization and investor sentiment 

Abasicfeatureofhumancognitionissimplificationthroughcategories.Forexample,the

label“BehavioralCorporateFinance”definesasetofpaperswithsimilarmethodologicalthemes

andfreesusfromhavingtoenumeratetheindividualmembersoftheset(exceptinthecaseofa

surveyarticle,ofcourse).TheclassictreatmentisRosch(1973),buttheprincipleisobviousand

needsnotheoreticalpreamble.

Investorsandanalystssimplifytheinvestmentuniversethroughcategories(Barberisand

Shleifer(2003)).Somecategories,suchassmall‐caps,valuestocks,high‐yieldstocks,andjunk

bonds,arefairlytimeless.Othersareephemeral.The“NiftyFifty”isaforgottenmonikerfromthe

early1970sforasetoflarge‐capitalizationfirmswithsolidearningsgrowth.Thesedays,“Internet

firms”isbecomingalessusefullabel.Itoncedenotedfirmswiththeessentialfeaturethattheir

successdependedontheadoptionofanewtechnology;thattechnologyisnowestablished,sothe

determinantsofthesefirms’prospectshavebecomemoreindividualized.

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Investmentcategoriesbecomeinterestingforuswheninvestorstradeatthecategorylevel.

Indexfundsprovideanexampleofcategory‐levelinvestinganditsconsequences:Whenastockis

addedtotheS&P500Index,itsreturnsbecomemorecorrelatedwithexistingIndexmembers

(Barberis,Shleifer,andWurgler(2005)).Itisnowtradedinsyncwiththem,and—arbitragebeing

limited—itacquiresacommonfactorinreturns.Overtime,thiscanleadtoadetachmentof

categorymembersfromtherestofthemarket(MorckandYang(2001),Wurgler(2011)).Themost

dramaticcasesarefrombubblesandcrashes.IntheInternetbubble,someinvestorsdidn’thavethe

timeorexpertisetoinvestigateindividualtechstocksandapparentlyjustthrewmoneyatanything

Internet‐related.Thecrashinvolvedequallyindiscriminateselling.Aqualitativereviewofstock

markethistorysuggeststhatinvestorsentimentoftenconcentratesatthelevelofcategories.

Forourpurpose,categorizationwillbeparticularlyrelevanttothediscussionofcatering

behavior,inwhichmanagerstakeactionstomovetheirfirmintothein‐voguecategoryandboost

itsvaluation.Thisboostmay,inturn,facilitateopportunisticsecuritiesissuance.

2.1.3.  Prospect theory, reference points, loss aversion, and anchoring  

IntheprospecttheorypreferencesofKahnemanandTversky(1979),utilityisdefinednot

asasmoothlyincreasingfunctionofthelevelofconsumptionorwealthbutintermsofchanges

relativetoareferencelevel.Viaakinkattheorigin,thevaluefunctionalsoembodiesloss

aversion—theempiricalphenomenonthatlosses,evensmallones,areparticularlypainful.See

TverskyandKahneman(1991)forasurveyoflossaversionresearch.

ThedispositioneffectofShefrinandStatman(1985)referstothepatternthatinvestorsare

morelikelytorealizegainsthanlosses.Atypicalexplanationinvokeselementsofprospecttheory:

thereferencepointisthepurchaseprice,andtheinvestorstrainstoavoidsellingatalossdespite

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thetaxadvantagetodoingso.3Othersalientreferenceprices,and,importantly,onesthatare

commonacrossinvestors,arerecenthighprices,suchasastock’sall‐timeor52‐weekhigh,and

recentlowprices.Huddart,Lang,andYetman(2009)findthattradingvolumeandreturnpatterns

changeasrecenthighsareapproachedforseasonedissues,andKaustia(2004)findsthattrading

volumebehaviorchangesasIPOsreachnewmaximaandminima.

TverskyandKahneman(1974)alsoreviewtheconceptofanchoring.Anchoringreferstoa

deviationfromBayesianbeliefs,notadeparturefromstandardpreferences.Inanchoring,the

subjectformsbeliefsbyadjustingfromapotentiallyarbitrarystartingpoint,andthebiasisthatthe

finalbeliefisbiasedtowardthisanchor;adjustmentawayfromitisinsufficient.Forexample,

TverskyandKahnemanaskedsubjectstoguesswhatfractionofAfricancountriesweremembersof

theUnitedNations.Thosewhowerefirstasked“isitmoreorlessthan10%?”guessedamedianof

25%,whilethosewhohadbeenasked”isitmoreorlessthan65%”guessedamedianof45%.

Offeringpayoffsforaccuracydidnotreducetheseeffects.AnotherexamplecomesfromStrackand

Mussweiler(1997),whoaskedsubjectstoestimatewhenEinsteinfirstvisitedtheUnitedStates.

Implausibleanchorslike1215and1992producedeffectsaslargeasanchorsof1909and1939.

Studiesinvolvingreferencepointthinking,lossaversion,andanchoringarefeaturedat

severalpointsinthissurvey.Thesephenomenahavebeenusedtoshedlightondividends,earnings

management,mergerofferprices,equityissuancetiming,hurdlerates,thecostofdebt,andother

patterns.

3BarberisandXiong(2009)andKaustia(2010b)showthatempiricalfeaturesofthedispositioneffectmakeithardtoconnecttoprospecttheoryperse,whichalsospecifiescurvatureinthevaluefunction.SeeKaustia(2010a)forathoroughsurveyofthedispositioneffectliterature.

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2.1.4.  Smart managers 

Buteveniflimitedarbitrageandsystematicinvestorbiasesadduptoinefficientmarkets,

whyisitreasonabletoassumethatcorporatemanagersare“smart”inthesenseofbeingableto

identifymispricing?Onecanofferseveraljustifications.First,corporatemanagershavesuperior

informationabouttheirownfirm.Thisisevidencedbytheabnormallyhighreturnsonillegal

insidertradinginMuelbroek(1992)andevenlegalinsidertradinginSeyhun(1992).

Second,managerscanmanufacturetheirowninformationadvantagebymanagingearnings

orwiththehelpofconflictedanalysts,asinBradshaw,Richardson,andSloan(2006).Theymay

alsobeabletoshapeinvestordemandthroughinvestorrelations,bymarketingtheirsharesinGao

andRitter(2010),orallocatingIPOsharesinZhang(2004).

Third,corporatemanagershavefewerconstraintsthanequally“smart”moneymanagers.

Considertwoclassicmodelsoflimitedarbitrageintroducedabove:DeLongetal.(1990)isbuilton

shorthorizonsandMiller(1977)onshort‐salesconstraints.CFOstendtobejudgedonlonger

horizonresultsthanaremoneymanagers,allowingthemtotakeaviewonmarketvaluationsina

waythatmostmoneymanagerscannot.4Short‐salesconstraintsalsopreventmoneymanagers

frommimickingCFOs.Whenafirmorasectorbecomesovervalued,corporationsarethenatural

candidatestoexpandthesupplyofshares.5Moneymanagersarenot.

Inaddition,managersmightjustfollowintuitiverulesofthumbthatallowthemtoidentify

mispricingevenwithoutanyrealinformationadvantage.InBakerandStein(2004),onesuch

4Forexample,supposethemanagerissuesequityat$50pershare.Shouldthosesharessubsequentlydouble,themanagermightregretnotdelayingtheissue,buthewillsurelynotbefired,havingpresidedoverariseinthestockprice.Incontrast,imagineamoneymanagersells(short)thesamestockat$50.Thismightleadtoconsiderablelossesforthefirmandtheexecutive,anoutflowoffunds,and,ifthebetislargeenough,perhapstheendofacareer.

5Conversely,whenthesharescrash,firmsserveasbuyersoflastresort(Hong,Wang,andYu(2008)).

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successfulruleofthumbistoissueequitywhenthemarketisparticularlyliquid,inthesenseofa

smallpriceimpactupontheissueannouncement.Inthepresenceofshort‐salesconstraints—more

onthisbelow—unusuallyhighliquidityissymptomaticofanovervaluedmarketdominatedby

irrationallyoptimisticinvestors.

Finally,inthecaseofdebtmaturity,firmsmayhaveacomparativeadvantageinexploiting

distortionsintheyieldcurve.Greenwood,Hanson,andStein(2010)developthislogic.Ina

Modigliani‐Millerworld,firmsareindifferenttotheirdebtmaturity,freeingthemtofillinthegapin

supplyatvariousmaturitiescreatedbyrestructuringoftheTreasurydebtmaturitystructureor

othernon‐fundamentalsupplyanddemandeffectsontheyieldcurve.Bycontrast,mutualfundand

institutionalinvestmentmanagersoftenhavelessflexibility,bymandateandotherlimitsof

arbitrage,tobeopportunisticintheirmaturitychoice.

2.2.  Theoretical framework: Rational managers in irrational markets 

Weusetheassumptionsofinefficientmarketsandsmartmanagerstodevelopasimple

theoreticalframeworkforthemarkettimingandcateringapproach.Theframeworkhasrootsin

FischerandMerton(1984),DeLong,Shleifer,Summers,andWaldmann(1989),Morck,Shleifer,

andVishny(1990b),andBlanchard,Rhee,andSummers(1993),butourparticularderivation

borrowsmostfromStein(1996).Newermodels,suchasBolton,Chen,andWang(2011),add

dynamicconsiderationstothisstaticframework.

Inthemarkettimingandcateringapproach,themanagerbalancesthreeconflictinggoals.

Thefirstistomaximizefundamentalvalue.Thismeansselectingandfinancinginvestmentprojects

toincreasetherationallyrisk‐adjustedpresentvalueoffuturecashflows.Tosimplifytheanalysis,

wedonotexplicitlymodeltaxes,costsoffinancialdistress,agencyproblemsorasymmetric

information.Instead,wespecifyfundamentalvalueas

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KKf , ,

wherefisincreasingandconcaveinnewinvestmentK.Totheextentthatanyoftheusualmarket

imperfectionsleadstheModigliani‐Miller(1958)theoremtofail,financingmayenterfalongside

investment.

Thesecondgoalistomaximizethecurrentsharepriceofthefirm’ssecurities.Inperfect

capitalmarkets,thefirsttwoobjectivesarethesame,sincethedefinitionofmarketefficiencyis

thatpriceequalsfundamentalvalue.Butonceonerelaxestheassumptionofinvestorrationality,

thisneednotbetrue,andthesecondobjectiveisdistinct.Inparticular,thesecondgoalisto“cater”

toshort‐terminvestordemandsviaparticularinvestmentprojectsorotherwisepackagingthefirm

anditssecuritiesinawaythatmaximizesappealtoinvestors.Throughsuchcateringactivities,

managersinfluencethetemporarymispricing,whichwerepresentbythefunction

,

wheretheargumentsofdependonthenatureofprevailinginvestorsentiment.Thearguments

mightincludeinvestinginaparticulartechnology,assumingaconglomerateorsingle‐segment

structure,changingthecorporatename,managingearnings,initiatingadividend,splittingshares,

andsoon.Inpractice,thedeterminantsofmispricingmaywellvaryovertime.

Thethirdgoalistoexploitthecurrentmispricingforthebenefitofexisting,long‐run

investors.Managersachievethisbya“markettiming”financingpolicywhichsuppliessecurities

thataretemporarilyovervaluedandrepurchasesthosethatareundervalued,oratleastless

overvalued.Thispolicytransfersvaluefromthenewortheoutgoinginvestorstotheongoing,long‐

14

runinvestors;thetransferisrealizedaspricescorrectinthelongrun.6Forsimplicity,wefocus

hereontemporarymispricingintheequitymarkets,andsoreferstothedifferencebetweenthe

currentpriceandthefundamentalvalueofequity.Moregenerally,eachofthefirm’ssecuritiesmay

bemispricedtosomedegree.Bysellingafractionofthefirme,longrunshareholdersgain

e .7

Weleaveoutthebudgetconstraintandlumptogetherthesaleofnewandexistingshares.Instead

ofexplicitlymodelingtheflowoffundsandanypotentialfinancialconstraints,wewillconsiderthe

reducedformimpactofeonfundamentalvalue.

Itisworthnotingthatothercapitalmarketimperfectionscanleadtoasortofcatering

behavior.Forexample,reputationmodelsinthespiritofHolmstrom(1982)canleadtoearnings

management,inefficientinvestment,andexcessiveswingsincorporatestrategyevenwhenthe

capitalmarketsarenotfooledinequilibrium.8Viewedinthislight,theframeworkhereisrelaxing

theassumptionsofrationalexpectationsinHolmstrom,inthecaseofcatering,andMyersand

Majluf(1984),inthecaseofmarkettiming.

6Ofcourse,wearealsousingthemarketinefficiencyassumptionhereinassumingthatmanagerialeffortstocaptureamispricingdonotfullyandinstantlydestroyitintheprocess,astheydointherationalexpectationsworldofMyersandMajluf(1984).Inotherwords,investorsunderreacttocorporatedecisionsdesignedtoexploitmispricingbecauseoflimitedarbitrage,attention,etc.

7Forlongrunshareholderstobenefit,weareimplicitlythinkingofsomethinglikethree‐periodmodel.Inthefirstperiod,investmentandfinancingdecisionsaremade,andpricesareabovefundamentalvaluebyanamount.Thereisanintermediateperiodwherepricesdonotchange,butshort‐runinvestorsselltheirshares,andafinalperiodwherefundamentalvalueisrealized.Issuingequitywilltheeffectofreducingpricesinthefirstandsecondperiodsife<0,whileincreasingthevaluepershareinthethirdperiodfromwhereitwouldotherwisebe.

8Forexamples,seeStein(1989)andScharfsteinandStein(1990).Foracomparisonofrationalexpectationsandinefficientmarketsinthisframework,seeAghionandStein(2008).

15

Puttingthegoalsoffundamentalvalue,catering,andmarkettimingintooneobjective

function,wehavethemanagerchoosinginvestmentandfinancingto

1,max,

eKKfeK

,

whereisgreaterthanzeroandlessthanorequaltooneandspecifiesthemanager’shorizon.

Whenequalsone,themanagercaresonlyaboutcreatingvalueforexisting,long‐run

shareholders,thelasttermdropsout,andthereisnodistinctimpactofcatering.However,and

interestingly,evenanextremelylong‐horizonmanagercaresaboutshort‐termmispricingforthe

purposesofmarkettiming,andthusmaycatertoshort‐termmispricingtofurtherthisobjective.

Withashorterhorizon,maximizingthestockpricebecomesanobjectiveinitsownright,even

withoutanyconcomitantequityissues.

Wetakethemanagerialhorizonasexogenouslysetbypersonalcharacteristics,career

concerns,andthecompensationcontract.Ifthemanagerplanstosellequityorexerciseoptionsin

thenearterm,hisportfolioconsiderationsmaylower.Careerconcernsandthemarketfor

corporatecontrolcanalsocombinetoshortenhorizons:ifthemanagerdoesnotmaximizeshort‐

runprices,thefirmmaybeacquiredandthemanagerfired.

DifferentiatingwithrespecttoKandegivestheoptimalinvestmentandfinancialpolicyofa

rationalmanageroperatingininefficientcapitalmarkets:

KK eKf

11, ,and

ee eKf

1, .

Thefirstconditionisaboutinvestmentpolicy.Themarginalvaluecreatedfrominvestment

isweighedagainstthestandardcostofcapital,normalizedtobeonehere,netoftheimpactthat

16

thisincrementalinvestmenthasonmispricing,andhenceitseffectthroughmispricingoncatering

andmarkettiminggains.Thesecondconditionisaboutfinancing.Themarginalvaluelostfrom

shiftingthefirm’scurrentcapitalstructuretowardequityisweighedagainstthedirectmarket

timinggainsandtheimpactthatthisincrementalequityissuancehasonmispricing,andhenceits

effectoncateringandmarkettiminggains.Thisisalottoswallowatonce,soweconsidersome

specialcases.

Investmentpolicy.InvestmentandfinancingareseparableifbothKandfeKareequalto

zero.ThentheinvestmentdecisionreducestothefamiliarperfectmarketsconditionoffKequalto

unity.Notethat,iffeisequaltozero,thereisnooptimalcapitalstructure.Realconsequencesof

mispricingforinvestmentariseintwoways.Eithercapitalstructurehasarealeffectonvalue,when

ef and eKf arenotequaltozero,orinvestmenthasadirecteffectonmispricing,when K isnot

equaltozero.Thesimplestsituationtoevaluateinthefirstcasehas K and e equaltozero.The

simplestsituationtoevaluateinthesecondcaseiswhen ef isequaltozero.Bothchannelsare

likelypresent,butanalyzingthetwoatthesametimereducestransparency.

InStein(1996)andBaker,Stein,andWurgler(2003),feandfeKarenotequaltozero.There

isanoptimalcapitalstructure,oratleastanupperboundondebtcapacity.Thebenefitsofissuing

orrepurchasingequityinresponsetomispricingarebalancedagainstthereductioninfundamental

valuethatarisesfromtoomuch(orpossiblytoolittle)leverageandtheindirecteffectonfirmvalue

throughinvestment,whenfeKisgreaterthanzero.Somewhatmoreformally,equityissueseare

increasinginanexogenouslevelofmispricing.(Thisalsorequirestheassumptionthatfeeisless

thanzero,whichisnecessaryforaninteriorsolutionforoptimalcapitalstructure.)TomatchBaker,

SteinandWurgler(2003),considerthecaseofanundervaluedfirm.Themoreundervaluedthe

firm,thelessequitythemanagersells.ThisconstrainsinvestmentwhenfeKisgreaterthanzero,i.e.

Kisincreasingine.(ConstraintsofthistypealsorequiretheassumptionthatfKKislessthanzero,

17

whichisnecessaryforaninteriorsolutionforinvestment.)Insum,becauseofundervaluationand

financialconstraints,themanagerchoosesacombinationoflowerequityissueseandlower

investmentKthanhewouldinthesituationofnomispricing.

InPolkandSapienza(2009)andGilchrist,Himmelberg,andHuberman(2005),thereisno

optimalcapitalstructure,butKisnotequaltozero:mispricingisitselfafunctionofinvestment.

Thepotentialtocreatemispricingdistortsinvestmentinasimple,directway.PolkandSapienza

focusoncateringeffectsanddonotconsiderfinancing(eequaltozerointhissetup),whileGilchrist

etal.modelthemarkettimingdecisionsofmanagerswithlonghorizons(equaltoone).

Financialpolicy.Thedemandcurveforafirm’sequityslopesdownunderthenatural

assumptionthateisnegative,e.g.,issuingsharespartlycorrectsmispricing.9Wheninvestmentand

financingareseparable,managersactlikemonopolists.Thisiseasiesttoseewhenmanagershave

longhorizons,andtheyselldownthedemandcurveuntilmarginalrevenueisequaltomarginal

cost–ee.Notethatpriceremainsabovefundamentalvalueevenaftertheissue:“corporate

arbitrage”movesthemarkettoward,butnotallthewayto,marketefficiency.10Managerssellless

equitywhentheycareaboutshort‐runstockprice(lessthanone,here).Forexample,in

Ljungqvist,Nanda,andSingh(2005),managersexpecttoselltheirownsharessoonaftertheIPO

andsoissuelessasaresult.Managersalsoselllessequitywhentherearecostsofsuboptimal

leverage.Tosomeextent,theshapeofthedemandcurvemaybeendogenous.GaoandRitter

(2010)arguethatfirmsactivelymarkettheirsharesinanticipationofanequityofferingwiththisin

mind.

9Gilchristetal.(2005)modelthisexplicitlywithheterogeneousinvestorbeliefsandshort‐salesconstraints.SeealsoHong,Wang,andYu(2008)).

10Totalmarkettiminggainsmaybeevenhigherinadynamicmodelwheremanagerscansellinsmallincrementsdownthedemandcurve.

18

Othercorporatedecisions.Thisframeworkcanbeexpandedtoaccommodatedecisions

beyondinvestmentandissuance.Considerdividendpolicy.Increasingorinitiatingadividendmay

simultaneouslyaffectbothfundamentalvalue,throughtaxes,andthedegreeofmispricing,if

investorscategorizestocksaccordingtopayoutpolicyastheydoinBakerandWurgler(2004a).

Thetradeoffis

dd eKf

1, ,

wheretheleft‐handsideisthetaxcostofdividends,forexample,andtheright‐handsideisthe

markettiminggain,ifthefirmissimultaneouslyissuingequity,plusthecateringgain,ifthe

managerhasshorthorizons.Inprinciple,asimilartradeoffgovernstheearningsmanagement

decisionorcorporatenamechanges;however,particularlyinthelattercase,thefundamentalcosts

ofcateringwouldpresumablybesmall.

2.3.  Empirical challenges 

Themarkettimingandcateringframeworkfeaturestheroleofsecuritiesmispricingin

investment,financing,andothercorporatedecisions.Themainchallengeforempiricaltestsinthis

areaismeasuringmispricing,whichbyitsnatureishardtopindown.Researchershave

operationalizedempiricaltestsinafewdifferentways.

Exantemisvaluation.Oneoptionistotakeanexantemeasureofmispricing,forinstancea

scaled‐priceratioinwhichamarketvalueinthenumeratorisrelatedtosomemeasureof

fundamentalvalueinthedenominator.Perhapsthemostcommonchoiceisthemarket‐to‐book

ratio:Ahighmarket‐to‐booksuggeststhatthefirmmaybeovervalued.Consistentwiththisidea,

andthepresumptionthatmispricingcorrectsinthelongrun,market‐to‐bookisfoundtobe

inverselyrelatedtofuturestockreturnsinthecross‐sectionbyFamaandFrench(1992)andinthe

time‐seriesbyKothariandShanken(1997)andPontiffandSchall(1998).Also,extremevaluesof

19

market‐to‐bookareconnectedtoextremeinvestorexpectationsbyLakonishok,ShleiferandVishny

(1994),LaPorta(1996),andLaPorta,Lakonishok,Shleifer,andVishny(1997).

Onedifficultythatariseswiththisapproachisthatthemarket‐to‐bookratiooranotherex

antemeasureofmispricingmaybecorrelatedwithanarrayoffirmcharacteristics.Bookvalueis

notapreciseestimateoffundamentalvalue,butratherasummaryofpastaccountingperformance.

Thus,firmswithexcellentgrowthprospectstendtohavehighmarket‐to‐bookratios,andthose

withagencyproblemsmighthavelowratios—andperhapstheseconsiderations,ratherthan

mispricing,driveinvestmentandfinancingdecisions.Dong,Hirshleifer,Richardson,andTeoh

(2003)andAngandCheng(2005)discountanalystearningsforecaststoconstructanarguablyless

problematicmeasureoffundamentalsthanbookvalue.

Anotherfactorthatlimitsthisapproachisthatapreciseexantemeasureofmispricing

wouldrepresentaprofitabletradingrule.Theremustbelimitstoarbitragethatpreventrational

investorsfromfullyexploitingsuchrulesandtradingawaytheinformationtheycontainabout

mispricing.

Expostmisvaluation.Asecondoptionistousetheinformationinfuturereturns.Theidea

isthatifstockpricesroutinelydeclineafteracorporateevent,onemightinferthattheywere

inflatedatthetimeoftheevent.However,asdetailedinFama(1998)andMitchellandStafford

(2000),thisapproachisalsosubjecttocritique.

Themostbasiccritiqueisthejointhypothesisproblem:apredictable“abnormal”return

mightmeantherewasmisvaluationexante,orsimplythatthedefinitionof“normal”expected

return(e.g.,CAPM)iswrong.Perhapsthecorporateeventsystematicallycoincideswithchangesin

risk,andhencethereturnrequiredinanefficientcapitalmarket.Anothersimplebutimportant

critiqueregardseconomicsignificance.Marketvalue‐weightingorfocusingonNYSE/AMEXfirms

mayreduceabnormalreturnsorcausethemtodisappearaltogether.

20

Therearealsostatisticalissues.Forinstance,corporateeventsareoftenclusteredintime

andbyindustry—IPOsareanexampleconsideredinBrav(2000)—andthusabnormalreturnsmay

notbeindependent.BarberandLyon(1997)andLyon,Barber,andTsai(1999)showthat

inferencewithbuy‐and‐holdreturns(foreachevent)ischallenging.Calendar‐timeportfolios,

whichconsistofanequal‐orvalue‐weightedaverageofallfirmsmakingagivendecision,have

fewerproblemshere,butthechangingcompositionoftheseportfoliosaddsanothercomplication

tostandardtests.LoughranandRitter(2000)alsoarguethatsuchanapproachisalesspowerful

testofmispricing,sincetheclusteredeventshavetheworstsubsequentperformance.Afinal

statisticalproblemisthatmanystudiescoveronlyashortsampleperiod.Schultz(2003)showsthat

thiscanleadtoasmallsamplebiasifmanagersengagein“pseudo”markettiming,making

decisionsinresponsetopastratherthanfuturepricechanges.

Analyzingaggregatetimeseriesresolvessomeoftheseproblems.Likethecalendartime

portfolios,timeseriesreturnsaremoreindependent.Therearealsoestablishedtime‐series

techniques,e.g.Stambaugh(1999),todealwithsmall‐samplebiases.Nonetheless,thejoint

hypothesisproblemremains,sincerationallyrequiredreturnsmayvaryovertime.

Butevenwhentheseeconometricissuescanbesolved,interpretationalissuesmayremain.

Forinstance,supposeinvestorshaveatendencytooverpricefirmsthathavegenuinelygood

growthopportunities.Ifso,eveninvestmentthatisfollowedbylowreturnsneednotbeexante

inefficient.Investmentmayhaverespondedtoomittedmeasuresofinvestmentopportunities,not

tothemisvaluationitself.

Thereareavarietyofwaystoimprovetheidentificationofachannelthatconnectscapital

marketmispricingtocorporatefinance.Baker(2009)outlinesanapproachbasedoninstrumenting

formispricingwithinvestortastesorothershockstothesupplyofcapital,andapproaches

involvingtheinteractionofmeasuresofvaluationormispricingwithlimitstoarbitrageor

21

corporateincentivestotimethemarket.Ofcourse,evenintheseapproachesusinginteraction

terms,onestillhastoproxyformispricingwithanexanteorexpostmethod.Totheextentthatthe

hypothesizedcross‐sectionalpatternappearsstronglyinthedata,however,objectionsaboutthe

measureofmispricinglosesomesteam.

Non‐fundamentalinvestordemand.Thefirstapproachistoidentifysupplyeffectswith

shiftsininvestordemand.Theideaistofindempiricalmeasuresthatarecorrelatedwithsentiment

orthesupplyofcapitalbutnotwithfundamentals.Thisissimpleenoughtowrite,buthardto

implement.Ifitwerepossibletoidentifymispricingsoclearly,suchmispricingmightnotarisein

thefirstplace.Someexamplesaremeasuresofinvestorinertia(Baker,Coval,andStein(2007)),

inattention(DellaVignaandPollet(2009)),localdemand(Becker,Ivkovic,andWeisbenner(2011)),

overconfidence(combinedwithshortsalesconstraintsinGilchrist,Himmelberg,andHuberman

(2005)),orindexadditions(Massa,Peyer,andTong(2005)).Morebroadly,shockstothecapitalof

intermediaries,whilenotnecessarilybehavioral,canbeusedtoassesstheimpactofcapitalmarket

inefficiencyoncorporatefinance.Thisistoolargealiteraturetosurveyhere.Thisapproachcomes

downtoreplacingadirectmeasureofvaluationwithaninstrumentforinvestordemand.

Cross‐sectionalinteractions:Limitstoarbitrage.Insituationswheretradingon

mispricingislimitedbyshort‐salesconstraints,transactioncosts,marginrequirements,regulation,

andfundamentalrisk,pricesarelikelytobefurtherfromfundamentalvalue,makingtheimpactof

capitalmarketinefficienciesoncorporatefinancemorelikely.Forexample,Baker,Foley,and

Wurgler(2009)arguethatthelimitsonarbitragearemoresevereinsomecountriesthanothers,

leadingtoadifferentialeffectofvaluationsofFDI.LamontandStein(2006)andGreenwood(2007)

makesimilarargumentsaboutrelativeefficiencytheimpactonstockissuanceandmergersand

acquisitions,andstocksplitsinJapan,respectively.Thisapproachcomesdowntoidentifying

marketconditionswheremispricingwillhavethestrongesteffect.

22

Cross‐sectionalinteractions:Corporateopportunism.Theeffectofcapitalmarket

inefficienciesoncorporatefinanceshouldbemostpronouncedamongthosefirmsexhibitingthe

meansandtheincentivetobeopportunistic.Inthisspirit,Baker,Stein,andWurgler(2003)

considerthepredictionthatiffeispositive,mispricingshouldbemorerelevantforfinancially

constrainedfirms.Moregenerally,managerialhorizonsorthefundamentalcostsofcateringto

sentimentmayvaryacrossfirmsinameasurableway.Forexample,BergstresserandPhillipon

(2006)showthatearningsmanagementismorepronouncedwhenmanagersarecompensated

withstockandoptions.Gaspar,Massa,andMatos(2005)arguethatmanagersinherittheir

investors’incentives,whichmaynotbechosenoptimallytomatchfirmfundamentals.This

approachcomesdowntoidentifyingfirmswheremispricingwillhavethestrongesteffect.

2.4.  Investment policy 

Ofparamountimportancearetherealconsequencesofmarketinefficiency.Itisonethingto

saythatinvestorirrationalityhasanimpactoncapitalmarketprices,orevenfinancingpolicy,

whichleadstotransfersofwealthamonginvestors.Itisanothertosaythatmispricingleadsto

underinvestment,overinvestment,orthegeneralmisallocationofcapitalanddeadweightlossesfor

theeconomyasawhole.Inthissubsectionwereviewresearchonhowmarketinefficiencyaffects

realinvestment,mergersandacquisitions,anddiversification.

2.4.1.   Real investment 

Inthemarkettimingandcateringframework,mispricinginfluencesrealinvestmentintwo

ways.First,investmentmayitselfbeacharacteristicthatissubjecttomispricing(thishappens

whenKisgreaterthanzeroabove).Investorsmayoverestimatethevalueofinvestmentin

particulartechnologies,forexample.Second,afinanciallyconstrainedfirm(thiscanhappenwhen

feKisgreaterthanzeroabove)maybeforcedtopassupfundamentallyvaluableinvestment

opportunitiesifitisundervalued.

23

Mostresearchhaslookedatthefirsttypeofeffect.Ofcourse,anecdotalevidenceofthis

effectcomesfrombubbleepisodes;itwaswiththelate1920sbubblefreshinmindthatKeynes

(1936)arguedthatshort‐terminvestorsentimentis,atleastinsomeeras,amajorordominant

determinantofinvestment.MorerecentUSstockmarketepisodesgenerallyviewedasbubbles

includetheelectronicsboomin1959‐62,growthstocksin1967‐68,the“niftyfifty”intheearly

1970s,gamblingstocksin1977‐78,naturalresources,hightech,andbiotechnologystocksinthe

1980s,andtheInternetinthelate1990s;seeMalkiel(1990)forananecdotalreviewofsomeof

theseearlierbubbles,andOfekandRichardson(2003)ontheInternet.SeeKindleberger(2000)for

anattempttodrawgenerallessonsfrombubblesandcrashesoverseveralhundredyears,andfor

anecdotalremarksontheirsometimes‐dramaticrealconsequences.

Anearlywaveofstudiesinthisareatestedwhetherinvestmentissensitivetostockprices

overandabovedirectmeasuresofthemarginalproductofcapital,suchascashfloworprofitability.

Ifitisnot,theyreasoned,thentheunivariatelinkbetweeninvestmentandstockvaluationslikely

justreflectsthestandard,efficient‐marketsQchannel.Thisapproachdidnotleadtoaclear

conclusion,however.Forexample,Barro(1990)arguesforastrongindependenteffectofstock

prices,whileMorck,Shleifer,andVishny(1990b)andBlanchard,Rhee,andSummers(1993)

concludethattheincrementaleffectisweak.

Themorerecentwaveofstudiestakesadifferenttack.Ratherthancontrollingfor

fundamentalsandlookingforaresidualeffectofstockprices,theytrytoproxyforthemispricing

componentofstockpricesandexaminewhetheritaffectsinvestment.Inthisspirit,Chirinkoand

Schaller(2001,2004),Panageas(2003),PolkandSapienza(2009),Gilchrist,Himmelberg,and

Huberman(2005),Massa,Peyer,andTong(2005),andSchaller(2011)allfindevidencethat

investmentissensitivetoproxiesformispricing.Ofcourse,thegenericconcernisthatthe

mispricingproxiesarestilljustpickingupfundamentals.Torefutethis,PolkandSapienzaaswell

24

asMassaetal.,forexample,considerthefinerpredictionthatinvestmentshouldbemoresensitive

toshort‐termmispricingwhenmanagerialhorizonsareshorter.PolkandSapienzafindthat

investmentisindeedmoresensitivetomispricingproxieswhenshareturnoverishigher,i.e.,where

theaverageshareholder’shorizonisshorter;theMassaetal.testissimilar.

Thesecondtypeofmispricing‐driveninvestmentistestedinBaker,Stein,andWurgler

(2003).Stein(1996)predictsthatinvestmentwillbemostsensitivetomispricinginequity‐

dependentfirms,i.e.firmsthathavenooptionbuttoissueequitytofinancetheirmarginal

investment,becauselong‐horizonmanagersofundervaluedfirmswouldratherunderinvestthan

issueundervaluedshares.Usingseveralproxiesforequitydependenceandmispricing,Bakeretal.

confirmtheprediction.

Overall,thereissomeevidencethatsomeportionoftheeffectofstockpricesoninvestment

isaresponsetomispricing,butkeyquestionsremain.Theactualmagnitudeoftheeffectof

mispricinghasnotbeenpinneddown,evenroughly.Theefficiencyimplicationsarealsounclear.

Titman,Wei,andXie(2004)andPolkandSapienza(2009)findthathighinvestmentisassociated

withlowerfuturestockreturnsinthecrosssection,andLamont(2000)findsasimilarresultfor

plannedinvestmentinthetimeseries.However,sentimentandfundamentalsseemlikelytobe

correlated,andso,asmentionedpreviously,eveninvestmentfollowedbylowreturnsmaynotbe

exanteinefficient.11Evengrantinganempiricallinkbetweenoverpricingandinvestment,itishard

todeterminetheextenttowhichmanagersarerationallyfanningtheflamesofovervaluation,asin

catering,oraresimplyjustasoveroptimisticastheirinvestors.Weshallreturntotheeffectsof

managerialoptimism.

11Asanexampleofthiscomplication,CampelloandGraham(2007)findthatfinanciallystrappednon‐techfirmsissuedequityduringtheInternetbubbleandusedittoinvest.Theunconstrainednon‐techfirmsdidnotshowthispattern.Thissuggestthatbubblesdrivenbyonecategorycanhavepositivespillovereffectsonrelativelyunrelatedfirms.

25

2.4.2.   Mergers and acquisitions 

ShleiferandVishny(2003)proposeamarket‐timingmodelofacquisitions.Theyassume

thatacquirersareovervalued,andthemotiveforacquisitionsisnottogainsynergies,butto

preservesomeoftheirtemporaryovervaluationforlong‐runshareholders.Specifically,by

acquiringless‐overvaluedtargetswithoverpricedstock(or,lessinterestingly,undervaluedtargets

withcash),overvaluedacquirerscancushionthefallfortheirshareholdersbyleavingthemwith

morehardassetspershare.Or,ifthedeal’svaluepropositioncaterstoaperceivedsynergythat

causesthecombinedentitytobeovervalued,asmighthavehappenedinthelate1960s

conglomerateswave(seebelow),thentheacquirercanstillgainalong‐runcushioneffect,while

offeringalargerpremiumtothetarget.

Themarkettimingapproachtomergershelpstounifyanumberofstylizedfacts.The

defensivemotivefortheacquisition,andtheideathatacquisitionsarefurtherfacilitatedwhen

cateringgainsareavailable,helptoexplainthetime‐serieslinkbetweenmergervolumeandstock

prices,e.g.,GolbeandWhite(1988).12Themodelalsopredictsthatcashacquirersearnpositive

long‐runreturnswhilestockacquirersearnnegativelong‐runreturns,consistentwiththefindings

ofLoughranandVijh(1997)andRauandVermaelen(1998).

Recentpapershavefoundfurtherevidenceformarkettiming‐motivatedmergers.Dong,

Hirshleifer,Richardson,andTeoh(2003)andAngandCheng(2005)findthatmarket‐level

mispricingproxiesandmergervolumearepositivelycorrelated,and(withinthis)thatacquirers

tendtobemoreoverpricedthantargets.13Theyalsofindthatoffersforundervaluedtargetsare

12SeeRhodes‐KropfandViswanathan(2004)forasomewhatdifferentmisvaluation‐basedexplanationofthislink.

13ArelatedpredictionoftheShleifer‐Vishnyframeworkisthatanovervaluedacquirercreatesvalueforlong‐termshareholdersbyacquiringafairlyvaluedorsimplylessovervaluedtarget.SavorandLu(2009)teststhispropositionbycomparingthereturnsofsuccessfulacquirerstothosethatfailforexogenousreasons,

26

morelikelytobehostile,andthatoverpricedacquirerspayhighertakeoverpremia.Rhodes‐Kropf,

Robinson,andViswanathan(2005)alsolinkvaluationsandmergeractivity.Bouwman,Fuller,and

Nain(2003)findevidencesuggestiveofashort‐termcateringeffect.Inhigh‐valuationperiods,

investorswelcomeacquisitionannouncements,yetthesubsequentreturnsofmergersmadein

thoseperiodsaretheworst.Baker,Foley,andWurgler(2009)findthatforeigndirectinvestment

(FDI),whichisoftencross‐borderacquisitions,increasewiththecurrentaggregatemarket‐to‐book

ratioofthesourcecountrystockmarketanddecreasewithsubsequentreturnsonthatmarket.All

ofthesepatternsareconsistentwithovervaluation‐drivenmergeractivity.

AnunresolvedquestionintheShleifer‐Vishnyframeworkiswhymanagerswouldprefera

stock‐for‐stockmergertoanequityissueifthemarkettiminggainsaresimilar.Oneexplanationis

thatamergermoreeffectivelyhidestheunderlyingmarkettimingmotivefrominvestors,because

theequityissueandinvestmentdecisionarebundled.Baker,Coval,andStein(2007)consider

anothermechanismthatcanalsohelpexplainagenericpreferenceforequityissuesviamerger.14

Thefirstingredientisthattheacquiringfirmfacesadownwardslopingdemandcurveforits

shares.Thesecondingredientisthatsomeinvestorsfollowthepathofleastresistance,passively

acceptingtheacquirer’ssharesasconsiderationevenwhentheywouldnothaveactively

participatedinanequityissue.Withthesetwoassumptions,thepriceimpactofastock‐financed

mergercanbemuchsmallerthanthepriceimpactofanSEO.Empirically,inertiaisamajorfeature

ininstitutionalandespeciallyindividualholdingsdatathatisassociatedwithsmallermerger

announcementeffects.

suchasaregulatoryintervention.Successfulacquirersperformpoorly,asinLoughranandVijh(1997),butunsuccessfulacquirersperformevenworse.

14Forexample,inthecaseofS&P100firmsover1999‐2001,FamaandFrench(2005)findthattheamountofequityraisedinmergersisroughly40timesthatraisedinSEOs.

27

2.4.3.   Diversification and focus 

Standardexplanationsforenteringunrelatedlinesofbusinessincludeagencyproblemsor

synergies,e.g.,internalcapitalmarketsandtaxshields.Likewise,movestowardgreaterfocusare

ofteninterpretedastriumphsofgovernance.Whileourmaintaskistosurveytheexisting

literature,thetopicsofdiversificationandfocushaveyettobeconsideredfromaperspective

whereinvestorsarelessthanfullyrational.So,wetakeashortdetourhere.Weaskwhetherthe

evidenceathandisconsistentwiththeviewthatthelate‐1960sconglomeratewave,whichledto

conglomeratessocomplextheywerestillbeingdivestedorbustedupdecadeslater,wasinpart

drivenbyeffortstocatertoatemporaryinvestorappetiteforconglomerates.

Investordemandforconglomeratesdoesappeartohavereachedapeakin1968.

RavenscraftandScherer(1987,p.40)findthattheaveragereturnon13leadingconglomerates

was385%fromJuly1965toJune1968,whiletheS&P425gainedonly34%.Diversifying

acquisitionswerebeinggreetedwithapositiveannouncementeffect,whileotheracquisitionswere

penalized(Matsusaka(1993)).Klein(2001)findsa“diversificationpremium”of36%from1966‐68

inasampleof36conglomerates.Perhapsrespondingtothesevaluationincentives,conglomerate

mergersacceleratedin1967andpeakedin1968(RavenscraftandScherer,pp.24,161,218).

Conglomeratevaluationsstartedtofallinmid‐1968.BetweenJuly1968andJune1970,the

samplefollowedbyRavenscraftandSchererlost68%,threetimesmorethantheS&P425.

Announcementeffectsalsosuggestaswitchininvestorappetites:diversificationannouncements

weregreetedwithaflatreactioninthemid‐tolate‐1970sandanegativereactionbythe1980s

(Morck,Shleifer,andVishny(1990a)).Kleinfindsthatthediversificationpremiumturnedintoa

discountof1%in1969‐71and17%by1972‐74,andadiscountseemstohaveremainedthrough

the1980s(LangandStulz(1994),BergerandOfek(1995)).Again,possiblyinresponsetothisshift

incateringincentives,unrelatedsegmentsbegantobedivested,startingalongtrendtowardfocus

28

(Porter(1987),KaplanandWeisbach(1992)).15Overall,whilesystematicevidenceislacking,the

driversofthediversificationandsubsequentre‐focuswavecouldberelatedtocatering.

2.5.   Financial policy 

Thesimpletheoreticalframeworksuggeststhatlong‐horizonmanagersmayreducethe

overallcostofcapitalpaidbytheirongoinginvestorsbyissuingoverpricedsecuritiesand

repurchasingunderpricedsecurities.Next,wesurveytheevidenceontheextenttowhichmarket

timingaffectsequityissues,repurchases,debtissues,cross‐borderissues,financialintermediation

(withthoughtsontherecentfinancialcrisis),andcapitalstructure.

2.5.1.   Equity issues 

Severallinesofevidencesuggestthatovervaluationisamotiveforequityissuance.Most

simply,intheGrahamandHarvey(2001)anonymoussurveyofCFOsofpubliccorporations,two‐

thirdsstatethat“theamountbywhichourstockisundervaluedorovervaluedwasanimportantor

veryimportantconsideration”inissuingequity(p.216).Severalotherquestionsinthesurveyalso

askabouttheroleofstockprices.Overall,stockpricesareviewedasmoreimportantthannineout

oftenfactorsconsideredinthedecisiontoissuecommonequity,andthemostimportantoffive

factorsinthedecisiontoissueconvertibledebt.

Empirically,equityissuanceispositivelyassociatedwithplausibleexanteindicatorsof

overvaluation.Pagano,Panetta,andZingales(1998)examinethedeterminantsofItalianprivate

firms’decisionstoundertakeanIPObetween1982and1992,andfindthatthemostimportantis

themarket‐to‐bookratioofseasonedfirmsinthesameindustry.Lerner(1994)findsthatIPO

15InacasestudyofthediversificationandsubsequentrefocusofGeneralMills,Donaldson(1990)writesthatthecompanyspentsomeeffort“toverifythedominanttrendsininvestorperceptionsofcorporateefficiency,asseeninthecompanystudyoftheimpactofexcessivediversificationonthetrendofprice‐earningsmultiplesinthe1970s”(p.140).

29

volumeinthebiotechsectorishighlycorrelatedwithbiotechstockindexes.Loughran,Ritter,and

Rydqvist(1994)findthataggregateIPOvolumeandstockmarketvaluationsarehighlycorrelated

inmostmajorstockmarketsaroundtheworld.Similarly,Marsh(1982)examinesthechoice

between(seasoned)equityandlong‐termdebtbyUKquotedfirmsbetween1959and1974,and

findsthatrecentstockpriceappreciationtiltsfirmstowardequityissuance.InUSdata,Jung,Kim,

andStulz(1996),Hovakimian,Opler,andTitman(2001),andErel,Julio,Kim,andWeisbach(2010)

alsofindastrongrelationshipbetweenstockpricesandseasonedequityissuance.

Therearemanynon‐mispricingreasonswhyequityissuanceandmarketvaluationsshould

bepositivelycorrelated,ofcourse.Morespecificevidenceforequitymarkettimingcomesfromthe

patternthatnewissuesearnlowsubsequentreturns.Inoneoftheearliestmoderntestsofmarket

efficiency,Stigler(1964)triedtomeasuretheeffectivenessoftheS.E.C.bycomparingtheexpost

returnsofnewequityissues(lumpingtogetherbothinitialandseasoned)from1923‐28withthose

from1949‐55.IftheS.E.C.improvedthepoolofissuers,hereasoned,thenthereturnstoissuersin

thelatterperiodshouldbehigher.Buthefoundthatissuersinbothperiodsperformedabout

equallypoorlyrelativetoamarketindex.Fiveyearsout,theaverageissuerinthepre‐S.E.C.era

laggedthemarketby41%,whiletheaverageunderperformanceinthelaterperiodwas30%.

Othersampleperiodsshowsimilarresults.Ritter(1991)examinesasampleofIPOs,Spiess

andAffleck‐Graves(1995)examineSEOs,andLoughranandRitter(1995)examineboth.16And,

Ritter(2003)updatestheseandseveralotherempiricalstudiesofcorporatefinancingactivities.

Thelastpaper’ssampleincludes7,437IPOsand7,760SEOsbetween1970and1990.Fiveyears

out,theaverageIPOearnslowerreturnsthanasize‐matchedcontrolfirmby30%,andtheaverage

SEOunderperformsthatbenchmarkby29%.GompersandLerner(2003)fillinthegapbetween

16Updateddataonthelong‐runreturnsofIPOsisavailableonJayRitter’swebsiteathttp://bear.warrington.ufl.edu/ritter/ipodata.htm.

30

thesamplesofStigler(1964)andLoughranandRitter(1995).Theirsampleof3,661IPOsbetween

1935and1972showsaveragefive‐yearbuy‐and‐holdreturnsthatunderperformthevalue‐

weightedmarketindexby21%to35%.17Thus,aseriesoflargeandnon‐overlappingsamples

suggeststhat,onaverage,USequityissuesunderperformthemarketsomewhereintheballparkof

20‐40%overfiveyears.

Inatestthatspeaksespeciallycloselytoopportunisticmarkettimingofequitysalestonew

investors,Burch,Christie,andNanda(2004)examinethesubsequentperformanceofseasoned

equityissuedviarightsoffers,whicharetargetedtoafirm’songoingshareholders,andfirm

commitmentoffers,whicharetargetedtonewshareholders.Intheir1933to1949sample,aperiod

inwhichrightsoffersweremorecommon,theyfindunderperformanceconcentratedentirelyinthe

lattergroup.Thisfitstheframeworkabove,whichemphasizestheopportunistictimingofequity

salestonewinvestors.

Muchevidencesuggeststhatinvestorsentimentvariesovertimeinitsstrengthandnature.

Forexample,stockmarketbubblescangrowandpopwithincertainindustries.Greenwoodand

Hanson(2011)exploitthisobservation.Theyfindthatnetequityissuancebyfirmswithdifferent

characteristics—size,shareprice,distressstatus,payoutpolicy,industry,andprofitability—helps

topredictreturnsonportfoliosdefinedonthosecharacteristics.Theirpaperisalsoaninteresting

contributiontobehavioralassetpricingandshowsthevalueofaunifiedperspective.Thatis,the

papersuggestshowthemisvaluationoffirmcharacteristicsatanygivenpointintime,anotherwise

difficultconcepttomeasure,isbetrayedbythefinancingactivityandmarkettimingmotivesof

firms.Wewillseemoreresultsofthissortinthecateringsection.

17GompersandLerneralsoconfirmwhatBravandGompers(1997)foundinalatersample:whileIPOshavelowabsolutereturns,andlowreturnsrelativetomarketindexes,theyoftendonotdoworsethanstocksofsimilarsizeandbook‐to‐marketratio.Oneinterpretationisthatsecuritieswithsimilarcharacteristics,whetherornottheyareIPOs,tendtobesimilarlypriced(andmispriced)atagivenpointintime.

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Ifequityissuesclusterwhenthemarketasawholeisovervalued,thenetgainstoequity

markettimingmaybeevenlargerthantheunderperformancestudiessuggest.BakerandWurgler

(2000)examinewhetherequityissuance,relativetototalequityanddebtissuance,predicts

aggregatemarketreturnsbetween1927and1999.Theyfindthatwhentheequitysharewasinits

tophistoricalquartile,theaveragevalue‐weightedmarketreturnoverthenextyearwasnegative

6%,or15%belowtheaveragemarketreturn.Henderson,Jegadeesh,andWeisbach(2006)finda

similarrelationshipinseveralinternationalmarketsovertheperiod1990to2001.In12outofthe

13marketstheyexamine,averagemarketreturnsarehigherafterabelow‐medianequityshare

yearthanafteranabove‐medianequityshareyear.18

Theequitymarkettimingstudiescontinuetobehotlydebated.Someauthorshighlightthe

usualjointhypothesisproblem,implicitlyproposingthatIPOsandSEOsdeliverlowreturns

becausetheyareactuallyfarlessrisky(andpricedaccordinglybyinvestors).Thisnotionstrikesus

asfanciful,butformoreonthisperspective,seeEckbo,Masulis,andNorli(2000),andEckboand

Norli(2004).Onastatisticalpoint,Schultz(2003)highlightsasmall‐sample“pseudomarket

timing”biasthatcanleadtoexaggeratedimpressionsofunderperformancewhenabnormal

performanceiscalculatedin“eventtime.”Theempiricalrelevanceofthisbiasisunclear.Schultz

(2003,2004)arguesthatitmaybesignificant,whileAng,Gu,andHochberg(2007),Dahlquistand

deJong(2004),andViswanathanandWei(2008)arguethatitisminor.19Thekeyissueconcerns

18Notethattheseaggregatepredictabilityresultsshouldprobablynotbeinterpretedasevidencethat“managerscantimetheaggregatemarket.”Amoreplausibleexplanationisthatbroadwavesofinvestorsentimentleadmanyfirmstobemispricedinthesamedirectionatthesametime.Then,theaveragefinancingdecisionwillcontaininformationabouttheaverage(i.e.,market‐level)mispricing,eventhoughindividualmanagersareperceivingandrespondingonlytotheirownfirm’smispricing.

19Butler,Grullon,andWeston(2005)takeSchultz’sideatothetime‐seriesandarguethattheequityshare’spredictivepowerisduetoanaggregateversionofthepseudomarkettimingbias.Baker,Taliaferro,andWurgler(2006)replythatthetestsinButleretal.havelittleactualrelevancetothebiasandthatstandardeconometrictechniquesshowthatsmall‐samplebiascanaccountforonlyonepercentoftheequityshare’sactualpredictivecoefficient.

32

thevarianceinthenumberofsecurityissuesovertime.Schultzassumesanonstationaryprocess

forthistimeseries.Thismeansthatthenumberofsecurityissuescanexplodeorcollapsetozero

forprolongedperiodsoftime,andhissimulatedvarianceofequityissuanceexceedstheactual

experienceintheU.S.

Inanycase,thereturnsstudies,havingbynaturelowpower,shouldnotbeconsideredin

isolation.Surveyevidencewasmentionedabove.OtherrelevantresultsincludeTeoh,Welch,and

Wong(1998a,b),whofindthattheequityissuerswhomanageearningsmostaggressivelyhavethe

worstpost‐issuereturns.JainandKini(1994),Mikkelson,Partch,andShah(1997),andPaganoet

al.(1998)findthatprofitabilitydeterioratesrapidlyfollowingtheinitialoffering,andLoughranand

Ritter(1997)documentasimilarpatternwithseasonedissues.Insidersellingalsocoincideswith

seasonedofferings,Jenter(2005)finds.Inaroundaboutbutnovelapproach,DellaVignaandPollet

(2011)hypothesizethatmanagersbutnotinvestorsrecognizetheeffectofdemographicshiftson

stockpricesinthenextfivetotenyears.Underamarkettimingpolicy,managerswillwaitforthose

shiftstopushup(down)pricestoissue(repurchase)equity;perhapssurprisingly,theyfind

evidenceforsuchaneffect.

Markettimingcanhelpresolveapuzzleofhoworwhyissuersareabletoraiseoutside

equitywhenpotentialagencycostsarehigh.InthetraditionalviewofJensenandMeckling(1976),

existingownersbearfutureagencycostsupfrontwhentheyraisenewequity,potentially

renderingoutsideequityprohibitivelycostly.Thisassumesofcoursethatoutsideinvestorsare

rationallycomputingthesecosts.Chernenko,Greenwood,andFoley(2010)findthatJapanesefirms

withthehighestagencycostsappeartoraisecapitalwhenperceptionsofagencycostsarelow.After

listing,theirsubsequentperformanceisverypoor,asifinvestorsperiodicallyignoredpotential

agencyproblems.

33

Viewedasawhole,theevidenceindicatesthatmarkettimingandattemptedmarkettiming

playaconsiderableroleinequityissuancedecisions.Thatsaid,DeAngelo,DeAngelo,andStulz

(2010)remindusthatseasonedequityissuancethatisnotassociatedwithmergersisstillan

infrequentevent.

2.5.2.   Repurchases 

Undervaluationisaveryimportantmotiveforrepurchases.Brav,Graham,Harvey,and

Michaely(2005)survey384CFOsregardingpayoutpolicy,and“themostpopularresponseforall

therepurchasequestionsontheentiresurveyisthatfirmsrepurchasewhentheirstockisagood

value,relativetoitstruevalue:86.6%ofallfirmsagree”(p.26).Anecdotally,repurchasescluster

afterunusualmarketcrashes:Hong,Wang,andYu(2008)highlighttherepurchasewavesthat

followedaftercrashesinOctober1987andSeptember11,2001.

Atthefirmlevel,repurchasersearnpositiveabnormalreturnsonaverage,suggestingthat

managersareonaveragesuccessfulintimingthem.Ikenberry,Lakonishok,andVermaelen(1995)

study1,239openmarketrepurchasesannouncedbetween1980and1990.Overthenextfour

years,theaveragerepurchaserearned12%morethanfirmsofsimilarsizeandbook‐to‐market

ratios.Ikenberry,Lakonishok,andVermaelen(2000)findsimilarresultsinasampleofCanadian

firms.Notethatthesereturnsarebenchmark‐adjustedandthereforedonotcountanysuccessful

timingofrepurchasesfrom,forexample,thereboundfromtheOctober1987crash.20

Theevidenceisthatmanagerstendtoissueequitybeforelowreturns,onaverage,and

repurchasebeforehigherreturns.Withoutknowingjusthowthe“rational”costofequityvaries

overtime,itisdifficulttoknowhowmuchthisactivityactuallyreducesthecostofequityforthe

averagefirm.However,supposethatrationallyrequiredreturnsareconstant.Byfollowing

20BakerandWurgler(2000)alsostudytheabilityofnetequityissuancetopredictmarketreturns.

34

aggregatecapitalinflowsandoutflowsintocorporateequities,andtrackingthereturnsthatfollow

theseflows,Dichev(2004)reportsthattheaverage“dollar‐weighted”returnislowerthanthe

averagebuy‐and‐holdreturnby1.3%peryearfortheNYSE/Amex,5.3%forNasdaq,and1.5%(on

average)for19stockmarketsaroundtheworld.Putdifferently,ifNYSE/Amexfirmshadissued

andrepurchasedrandomlyacrosstime,then,holdingthetimeseriesofrealizedreturnsfixed,they

wouldhavepaid1.3%peryearmorefortheequitycapitaltheyemployed.

Ofcourse,thisreductioninthecostofequitycapitalisnotevenlydistributedinthecross

sectionoffirms.Thecompositionoffirmsinpositiontorepurchase,forexample,variesovertime,

asshownbyGreenwoodandHanson(2011),inaccordwithvaluation.Thestaticdifference

betweenNasdaqandNYSE/Amexalsogivesahintofthis.Forthemanymaturefirmsthatrarely

raiseexternalequity,thegainsmaybenegligible.Forotherfirmsthataccessthecapitalmarkets

repeatedlythroughseasonedequityissuesandstock‐financedmergers,thegainsmaybemuch

larger.

2.5.3.   Debt issues 

Afewpapershaveexamineddebtmarkettiming—raisingdebtwhenitscostisunusually

low.Surveyevidenceofferssupportformarkettimingbeingafactorindebtissuancedecisions.

GrahamandHarvey(2001)findthatinterestratesarethemostcitedfactorindebtpolicy

decisions:CFOsissuedebtwhentheyfeel“ratesareparticularlylow.”Expectationsabouttheyield

curvealsoappeartoinfluencethematurityofnewdebt.Short‐termdebtispreferred“whenshort‐

termratesarelowcomparedtolong‐termrates”andwhen“waitingforlong‐termmarketinterest

ratestodecline.”Whiletheformerstatementwouldbeconsistentwiththepreferenceforalow

interestratestopumpupearnings(Stein(1989)),thelatterclearlyindicatesaskepticisminthe

textbookexpectationshypothesis,whichpositsthatthecostofdebtisequalacrossmaturities.At

35

thesametime,CFOsdonotconfesstoexploitingtheirprivateinformationaboutcreditquality,

insteadhighlightinggeneraldebtmarketconditions.

Ontheempiricalside,Marsh(1982),inhissampleofUKfirms,findsthatthechoice

betweendebtandequitydoesappeartobeswayedbythelevelofinterestrates.GuedesandOpler

(1996)examineandlargelyconfirmthesurveyresponsesregardingtheeffectoftheyieldcurve.In

asampleof7,369USdebtissuesbetween1982and1993,theyfindthatmaturityisstrongly

negativelyrelatedtothetermspread(thedifferencebetweenlong‐andshort‐termbondyields),

whichfluctuatedconsiderablyduringthisperiod.

Isthereanyevidencethatdebtmarkettimingissuccessful?Inaggregatedata,Baker,

Greenwood,andWurgler(2003)examinetheeffectofdebtmarketconditionsonthematurityof

debtissuesand,perhapsmoreinterestingly,connectthematurityofnewissuestosubsequentbond

marketreturns.Specifically,inUSFlowofFundsdatabetween1953and2000,theaggregateshare

oflong‐termdebtissuesintotallong‐andshort‐termdebtissuesisnegativelyrelatedtotheterm

spread,justasGuedesandOplerfindwithfirm‐leveldata.Further,becausethetermspreadis

positivelyrelatedtofutureexcessbondreturns—i.e.thedifferenceinthereturnsoflong‐termand

short‐termbonds,ortherealizedrelativecostoflong‐andshort‐termdebt—soisthelong‐term

shareindebtissues.Perhapssimplybyusinganaïveruleofthumb,“issueshort‐termdebtwhen

short‐termratesarelowcomparedtolong‐termrates,”managersmayhavetimedtheirdebt

maturitydecisionssoastoreducetheiroverallcostofdebt.Ofcourse,suchaconclusionissubject

totheusualrisk‐adjustmentcaveats.

Greenwood,Hanson,andStein(2008)godeeperintotheeffectofdebtmarketefficiencyon

maturitystructure,andwhileitfallswithinthemarkettimingspiritithastheappealingfeaturethat

itdoesnotrequirethatfirmshaveadebtmarketforecastingability.Specifically,theyarguethat

thereareshockstosupplyofbondsatdifferentpointsintheyieldcurve,forexamplechangesinthe

36

maturitystructureofgovernmentdebt,thatintroducecorrespondingmispricingsalongtheyield

curve.Anyonecanobservethese.Givenlimitedarbitrageontheinvestorside,firmsthatare

indifferenttotheirdebtmaturity(inthisotherwiseModigliani‐Millerworld)cansupplydebtatthe

mispricedterm,limitedonlybytheirsize.

Unfortunately,thedataonindividualdebtissuesandtheirsubsequentreturnsdoesnot

approachthelevelofdetailoftheIPOandSEOdata.Butoneintriguingpatternthathasbeen

uncoveredisthatdebtissues,muchlikeequityissues,arefollowedbylowequityreturns.Spiess

andAffleck‐Graves(1999)examine392straightdebtissuesand400convertibleissuesbetween

1975and1989.Thesharesofstraightdebtissuersunderperformasize‐andbook‐to‐market

benchmarkbyaninsignificant14%overfiveyears(themedianunderperformanceissignificant),

whileconvertibleissuersunderperformbyasignificant37%.Thereisalsoasuggestionthatthe

riskiestfirmsmaybetimingtheiridiosyncraticcreditquality,despitethesurveyanswersonthis

point:thesharesofunratedissuershaveamedianfive‐yearunderperformanceof54%.Ifthe

equitydidsopoorly,thedebtissuespresumablyalsodidpoorly.Inamuchbroaderpanel,

RichardsonandSloan(2003)alsofindthatnetdebtissuanceisfollowedbylowstockreturns.

Thereareseveralpotentialexplanationsforthispattern.Certainly,equityovervaluation

wouldbeexpectedtolowerthecostofdebtdirectly,becausecreditriskmodelsroutinelyinclude

stockmarketcapitalizationasaninput,sotherelationshipwithsubsequentstockreturnsmay

reflectdebtmarkettimingperse.Or,perhapsmanagerialandinvestorsentimentiscorrelated;

managersmaytendtobemostoptimisticpreciselywhencapitalischeap,andthusraiseandinvest

asmuchastheycanfromanysource.Thisstorycombinesinvestorandmanagerialirrationalityand

sodoesnotfitneatlywithinthemarkettimingframework,butmayhavesometruth.Athird

possibility,outlinedinBaker,Stein,andWurgler(2003),isthatequityovervaluationrelaxesa

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bindingleverageconstraint,creatingdebtcapacitythatsubsequentlygetsusedup.Butdebtis

alwayscorrectlypricedinthissetting,sodebtmarkettimingperseisnotpossible.

2.5.4.   Cross‐border issues 

Thestudyofdual‐listedsharesbyFrootandDabora(1999)showsthatevenhighlyliquid

marketssuchastheUSandtheUKcanattachdifferentpricestothesamecashflowstream.This

raisesthepossibilityoftimingacrossinternationalmarkets.Alongtheselines,GrahamandHarvey

(2001)findthatamongUSCFOswhohaveconsideredraisingdebtabroad,44%implicitly

dismissedcoveredinterestparityinreplyingthatlowerforeigninterestrateswereanimportant

considerationintheirdecision.21

Inpractice,mostinternationalstockandbondissuesaremadeontheUSandUKmarkets.

Henderson,Jegadeesh,andWeisbach(2006)findthatwhentotalforeignissuesintheUSortheUK

arehigh,relativetorespectiveGDP,subsequentreturnsonthosemarketstendtobelow,

particularlyincomparisontothereturnsonissuers’ownmarkets.Inasimilarvein,andconsistent

withthesurveyevidencementionedabove,foreignfirmstendtoissuemoredebtintheUSandthe

UKwhenratestherearelowrelativetodomesticrates.

2.5.5.   Financial intermediation 

Ourfocusismostlyonthefinancingdecisionsoffirms,butfinancialintermediariesoften

playacriticalrolebetweenfirmsandtheultimateinvestors.Totheextentthatcapitalmarket

inefficienciesaffectcorporatefinance,aninterestingquestionishowintermediariesaffectissuance

andinvestmentpatternsandwhethertheyplayastabilizingordestabilizingrole.Theroleof

financialintermediariesinbehavioralcorporatefinanceisaninterestingquestioninitsownright

thatdeservesmoreresearchattention.Wementionpapersintheareaofbanking,privateequity,

21AlmostallequityraisedbyUScorporationsisplacedindomesticmarkets,soGrahamandHarveydonotaskaboutthedeterminantsofinternationalstockissues.

38

andventurecapital.Thesequestionsobviouslyloomlargeinlightoftherecentfinancialcrisis,

whichwediscussnext.

Banksarenotdissimilartofirmsinthattheyhavethesamemarkettimingmotivestosell

overvaluedsecuritiesandbuybacksecuritiesthatareundervalued.Motivatedbythecrisis,Shleifer

andVishny(2010)modelhowfinancialintermediariescantakeadvantageofinvestorsentimentin

thiswaythroughsecuritizedlending—creatingandsellingoverpricedassets.Thiscreatesachannel

forbankstotransmitsentiment‐drivenmispricingintorealeffects.Intheirmodel,banksretaina

fractionoftheirloans.Afterahaircut,thevalueoftheseloansdetermineshowmuchtheycan

borrowshort‐term.Whenloanvaluesarehigh,borrowingtomakemoreofthemandexpandthe

balancesheetandfinancemorerealinvestmentissoprofitablethatitisworththeriskofhavingto

liquidatetheirholdingsifandwhenpricesfallbelowfundamentals.AsCharlesPrince,theCEOof

Citigroup,famouslysaidinJuly2007,“Whenthemusicstops,intermsofliquidity,thingswillbe

complicated.Butaslongasthemusicisplaying,you’vegottogetupanddance.We’restilldancing.”

Asaresult,farfrombeinginapositiontobuyunderpricedloansandstabilizethemarket,or

financenewinvestment,bankscandeepenacrisis.

Fang,Ivashina,andLerner(2010)findevidenceofopportunisminbankinvolvementin

privateequity.Inparticular,banks’shareofprivateequitytransactionspeakswhentheprivate

equitymarketisexperiencinglargeinflows.Moreover,transactionsdoneatmarketpeaksaremore

likelytoturnoutpoorly.Abroaderviewofprivateequityisthatitprofitsfromtheimperfect

integrationbetweencreditandequitymarkets.Occasionally,borrowingtofinancethepurchaseof

publicorprivatefirmsischeaprelativetothecostofequitycapital,enticingtheshareofprivate

equityinmergersandacquisitionstocheap.Becausethisispurelyatimeseriesview,andprivate

equityhasashorthistory,itisdifficulttoprove.However,Axelson,Jenkinson,Stromberg,and

Weisbach(2010)providecorroboratingevidenceofalinkbetweenfinancingcostsanddealpricing.

39

Ithasbeensuggestedthatintermediariescancausefinancialmarket“dislocations”to

propagatefromonesetoffirmstoanother,affectingrealactivity.Townsend(2011)considersthe

caseofventurecapital,whereinformationasymmetrycanleadtotheportfoliofirmbeinglocked

intoarelationshipwithonecapitalprovider,e.g.asinRajan(1992).HefindsthataftertheInternet

bubbleburst,non‐techfirmshaddifficultygettingfollow‐onfundingiftheirventurecapitalistshad

hightechexposure.Thequestioniswhyventurecapitalistsdonotrespondbydiversifyingtheir

portfoliosorreservingcapitalforfollow‐onofferings.ThisisinthesamespiritastheShleifer‐

Vishnymodel,whereinthiscasethelureofresellingInternetfirmstoafrothymarketisso

profitablethatitisworththeriskofbeingshortofcapitalintheeventofacollapse.

Therecentfinancialcrisishasmanydifferentelements,fromthedecisionsofindividual

borrowerstotheultimatepurchasersofmortgagebackedsecurities,andtheinvolvementof

numerousintermediaries,includingmortgagebrokers,mortgagebanks,investmentbanksand

otherunderwritersofmortgage‐backedandothercollateralizeddebtobligations(CDOs),ratings

agencies,bondinsurers,andthegovernment‐sponsoredentities,FannieMaeandFreddieMac.Itis

nosurprisethatthereisnotatidybehavioral,orrational,explanationtoitscausesoritsultimate

realconsequences.Barberis(2011)makessignificantprogressinthisdirection.Wedonothave

roomtofullysurveytheburgeoningliteratureonthecrisishere.

Abehavioralviewofthecrisisstartswiththeobservationthatlessthanfullyrational

demandwastheunderpinningoftwinbubblesinrealestateandthedebtcontractsunderlyingreal

estateandothersimilarassets.Thereareavarietyofexplanations.Forexample,investorsand

ratingsagenciesneglectedararebutnotzeroprobabilitybadstateandovervaluedquasi‐AAA

securitiesinGennaioli,Shleifer,andVishny(2011).Realestateandcreditinstrumentswere

difficulttoshort,sodifferencesofopinionmayhaveledtoovervaluation.Or,mostsimply,investors

extrapolatedshorthistoriesofhighrealestatereturnsandlowdefaultprobabilities.Greenwood

40

andHanson(2010)findpredictabilityinamuchlongertimeseriesofreturnsoncredit.Aperiodof

highreturnsonriskydebtandloosenedcreditstandardsispredictablyfollowedbylowerreturns.

Institutionsplayedarole,cateringtoinvestordemandforsafeassets.Investmentbanks

createdseeminglylowriskassetswithpoolingandtranching.Thiscombinedinsomecaseswith

bondinsuranceincreasedthesupplyforAAAsecurities.CovalandStafford(2010)arguethat

ratingsagenciesfocusedondefaultprobabilities,neglectingthepriceofriskforseniortranchesof

CDOs.Thisisamoresubtleargumentthantheconflictsofinterestofissuerspayingtheratings

agenciesforanopinionthathavebeenhighlightedbypoliticiansandthemedia.

Adefiningfeatureofthefinancialcrisiswasthatsystemicallyimportantbanksretaineda

significantexposuretoalltypesofmortgagesecurities.Thereareanumberofexplanations.Oneis

thattheysimplycarriedinventoryofmortgagesandwereleftwiththesesecuritiesontheirbalance

sheetsatthestartofthefinancialcrisis.UnlikeInternetIPOs,CDOsrequiredtimeandbankcapital

toassemble.Asecondexplanationisthattheyintentionallytookriskswithlimitedbankcapital,

intentionallygamblingonapositiveoutcomeinthemortgagemarkets.Thismoralhazardviewhas

shapedthedebateinfinancialreform.AchallengetothisviewisthattheleadershipofBearStearns

andLehmanBrotherswhowereinapositiontochangeleveragehadalotatstake,andindeedlost

muchoftheirwealthin2008.Athirdexplanationisthattherewereagencyproblemswithinthe

firmandthestructuredfinancegroupswiththemostinformationaboutthesemarketsdidnot

sharewithmanagement.Afinalexplanationisthattheywereconvincedbytheirownmarketingor,

relatedly,theywerefocusedonshort‐termperformanceandthehighpricesofmortgagesecurities

thatchangedhandspriortothecrisis.Thisbelongstothesectiononlessthanfullyrational

managers.Whetherthiswasoverconfidence,cognitivedissonance,oralargersociological

phenomenonishardtopindown.

41

Afewgeneralobservationsareworthmakingaboutrecentfinancialcrises.Boththe

Internetcrashandthefinancialcrisisstartedwithsignificantassetpricebubbles,bothalso

involvedtheactiveoratleastcomplicitparticipationoffinancialintermediaries,butthefinancial

crisisinvolvedmuchmoredirectexposurewithinthebankingsystem—andhencelargerreal

consequences.Moreover,bothseemtoinvolveequalpartsofagencyproblemswithininstitutions

andinvestorsentiment.

2.5.6.   Capital structure 

Asanaccountingidentity,afirm’scapitalstructureisthecumulativeoutcomeofalong

seriesofincrementalfinancingdecisions,eachdrivenbytheneedtofundsomeinvestmentproject,

consummateamerger,refinanceorrebalance,orachievesomeotherpurpose.Totheextentthat

markettimingisadeterminantofanyoftheseincrementalfinancingdecisions,then,itmayhelpto

explainthecross‐sectionofcapitalstructure.Inparticular,ifmarkettiming‐motivatedfinancing

decisionsarenotquicklyrebalancedaway,low‐leveragefirmswilltendtobethosethatraised

externalfinancewhentheirstockpriceswerehigh,andhencethosethattendedtochooseequityto

financepastinvestmentsandmergers,andvice‐versaforhighleveragefirms.22

SuchamarkettimingtheoryofcapitalstructureisoutlinedinBakerandWurgler(2002).In

anefforttocapturethehistoricalcoincidenceofmarketvaluationsandthedemandforexternal

financeinasinglevariable,theyconstructan“externalfinanceweighted‐average”ofafirm’spast

market‐to‐bookratios.Forexample,ahighvaluewouldmeanthatthefirmraisedthebulkofits

externalfinance,equityordebt,whenitsmarket‐to‐bookwashigh.Ifmarkettiminghasa

persistentimpactoncapitalstructure,thisvariablewillhaveanegativecross‐sectionalrelationship

22Similarly,debtmaturitystructurecouldtosomeextentreflectthehistoricalcoincidenceofdebt‐raisingneedsanddebtmarketconditionslikethetermspread.

42

tothedebt‐to‐assetsratio,eveninregressionsthatcontrolforthecurrentmarket‐to‐bookratio.In

abroadCompustatsamplefrom1968to1999,astrongnegativerelationshipisapparent.

Thisevidencehasinspireddebate.Ononehand,Hovakimian(2006)arguesthatequity

issuesdonothavepersistenteffectsoncapitalstructure,andthattheexplanatorypowerofthe

weightedaveragemarket‐to‐bookarisesbecauseitcontainsinformationaboutgrowth

opportunities,alikelydeterminantoftargetleverage,thatisnotcapturedincurrentmarket‐to‐

book.LearyandRoberts(2005),KayhanandTitman(2004),FlanneryandRangan(2006)also

arguethatfirmsrebalancetowardatarget.Alti(2006)looksspecificallyatthetimeseriesvariation

inIPOleverage,findingthataninitialandstatisticallysignificantresponsetohotissuesmarketsis

short‐lived.

Ontheotherhand,HuangandRitter(2009)showthatthetendencytofundafinancing

deficitwithequitydecreaseswhenthecostofequityislow.Furthermore,Welch(2004)andHuang

andRitter(2009),likeFamaandFrench(2002),arguethatfirmsrebalancetheircapitalstructures

muchmoreslowly,sothatshockstocapitalstructurearelonglived.And,inanyevent,Chenand

Zhao(2007)pointoutthatmeanreversioninleverageisnotdefinitiveevidenceforatradeoff

theory.Leverageisaratio,soshockstendtocausemeanreversionmechanically.Inananalysisof

thechoicebetweenequityanddebtissues,whichavoidsthisproblem,ChenandZhao(2005)find

thatdeviation‐from‐targetproxieshavelittleexplanatorypower,whilemarket‐to‐bookandpast

stockreturnsareveryimportant.

43

2.6.   Other corporate decisions 

Inthissubsection,weconsiderwhatthemarkettimingandcateringapproachhastosay

aboutdividendpolicy,firmnamechanges,andearningsmanagement.23Wealsodiscussworkthat

looksatexecutivecompensationfromthisperspective.

2.6.1.   Dividends 

Thecateringideahasbeenappliedtodividendpolicy.Long(1978)providessomeearly

motivationforthisapplication.HefindsthatshareholdersofCitizensUtilitiesputdifferentprices

onitscashdividendshareclassthanitsstockdividendshareclass,eventhoughthevalueofthe

shares’payoutsareequalbycharter.Inaddition,thisrelativepricefluctuates.Theunique

experimentsuggeststhatinvestorsmayviewcashdividendsperseasasalientcharacteristic,andin

turnraisesthepossibilityofacateringmotiveforpayingthem.

BakerandWurgler(2004a)testacateringtheoryofdividendsinaggregateUSdata

between1963and2000.Theyfindthatfirmsinitiatedividendswhenthesharesofexistingpayers

aretradingatapremiumtothoseofnonpayers,anddividendsareomittedwhenpayersareata

discount.Tomeasuretherelativepriceofpayersandnonpayers,theyuseanexantemeasureof

mispricingtheycallthe“dividendpremium,”whichisjustthedifferencebetweentheaverage

market‐to‐bookratiosofpayersandnonpayers.Theyalsouseexpostreturns,andfindthatwhen

therateofdividendinitiationincreases,thefuturestockreturnsofpayers(asaportfolio)arelower

thanthoseofnonpayers.Thisisconsistentwiththeideathatfirmsinitiatedividendswhenexisting

payersarerelativelyoverpriced.LiandLie(2006)findsimilarresultsfordividendchanges.

23Weputdividendpolicyinthissectionandrepurchasesinthefinancingsection,because,unlikearepurchase,pro‐ratadividendsdonotchangetheownershipstructureofthefirm,andthereisnomarkettimingbenefitorcost.Forthisreason,itfitsmorenaturallywiththecategoryofcorporatedecisionsthatmightinfluencethelevelofmispricing,butdonotbythemselvestransfervalueamonginvestors.

44

Time‐varyingcateringincentivesshedmuchlightonthe“disappearance”ofdividends.

FamaandFrench(2001)documentthatthepercentageofCompustatfirmsthatpaydividends

declinesfrom67%in1978to21%in1999,andthatonlyapartofthisisduetothecompositional

shifttowardssmall,unprofitable,growthfirmswhicharegenerallylesslikelytopaydividends.

BakerandWurgler(2004b)documentthatthedividendpremiumswitchedsignfrompositiveto

negativein1978andhasremainednegativethrough1999,suggestingthatdividendsmayhave

beendisappearinginpartbecauseoftheconsistentlylowervaluationsputonpayersoverthis

period.Ananalysisofearlier1963‐77dataalsolendssupporttothisidea.Dividends“appeared,”

“disappeared,”andthen“reappeared”inthisperiod,andeachshiftroughlylinesupwithaflipin

thesignofthedividendpremium.InUKdata,Ferris,Sen,andYui(2006)findthatdividendshave

beendisappearingduringthelate1990s,andthatadividendpremiumvariableformedusingUK

stockslinesupwiththispattern.

Supposingthatdividendsupplydoesrespondtocateringincentives,whydoesinvestor

demandforpayersvaryovertimeinthefirstplace?Onepossibilityisthat“dividendclienteles”

varyovertime,forexamplewithtaxcodechanges.However,inUSdata,thedividendpremiumis

unrelatedtothetaxdisadvantageofdividendincome,asistherateofdividendinitiation.Shefrin

andStatman(1984)developexplanationsforwhyinvestorspreferdividendsbasedonself‐control

problems,prospecttheory,mentalaccounting,andregretaversion.Perhapstheseelementsvary

overtime.BakerandWurgler(2004a)arguethatthedividendpremiumreflectssentimentfor

“risky”nonpayinggrowthfirmsversus“safe”dividendpayers,sinceitfallsingrowthstockbubbles

andrisesincrashes;FullerandGoldstein(2011)showexplicitlythatpayersoutperforminmarket

downturns.Anecdotalevidencesuggeststhatsomeinvestorsflocktotheperceivedsafetyof

dividendsingloomyperiods,andbiduppayers’prices,atleastinrelativeterms,intheprocess.

45

Therearelimitationstoacateringtheoryofdividends.Forone,itisadescriptivetheoryof

whetherfirmspaydividendsatall,nothowmuch—inUSdata,atleast,thedividendpremiumdoes

notexplainaggregatefluctuationsinthelevelofdividends.DeAngelo,DeAngelo,andSkinner

(2004)reportthattheaggregatedollarvalueofdividendshasincreasedinrealterms,asdividends

havebecomeconcentratedinasmallerfactionoftradedfirms.Also,thetheoryworksbetterfor

explaininginitiationsthanomissions,andithaslittletosayaboutthestrongpersistencein

dividendpolicy.Catering,likeagencyorasymmetricinformationortaxes,isbestviewedasone

elementinanoveralltheoryofdividendpolicy.Aswewillseelater,itisnoteventheonlyapproach

todividendsthatbehavioralcorporatefinanceoffers.

2.6.2.   Earnings management 

Thequarterlynetincomefigurethatmanagersreporttoshareholdersdiffersfromactual

economiccashflowsbyvariousnon‐cashaccruals,somediscretionary.Thisbecomesinteresting

when,asdocumentedinthesurveybyGraham,Harvey,andRajgopal(2005),CFOsbelievethat

investorscaremoreaboutearningspersharethancashflows.

Indeed,certainpatternsinreportedearningsnumbersareclearlyshapedbycatering

concerns.MostprominentamongthesearethereferencepointsdocumentedbyDegeorge,Patel,

andZeckhauser(1999).Earningsaremanagedtoexceedthreesalientthresholds.Inorderof

importance,thesearepositiveearnings,pastreportedearnings,andanalysts’expectations.

Interestingly,theshapeoftheearningsdistributionsshowthatthethresholdisgenerallymetfrom

below:firmsnearthethresholdsstretchtomeetthem,nottreatingthemaslowerboundsand

shiftingearningstothefuture.24Carslaw(1988)andBernard(1989)findthatreportedearnings

andearningspershareclusteratsalientroundnumbers,suchasmultiplesoffiveortencents.

24Inthebehavioralsignalingsectionofthepaper,wediscussamoredynamicmodelwithbothfeatures.

46

Thesepatternsdonotholdfornegativeearnings,however;apparently,managersdowhateverthey

cantodistractattentionfrombadresults.

Thesepatternshaveaflavorofcateringtoshareholderlossaversionrelativetosalient

earningsreferencepoints.Atthesametime,therearenon‐behavioralcontributorstothese

patterns.First,earningsmanagementcanbeaNashequilibriumresult(Stein(1989))under

asymmetricinformation.Second,managerialbonusesordebtcontractsmaybeconditionalon

earningsperformancerelativetosimplebenchmarks.Ofcourse,theuseofsuchcontractsbegsthe

questionwhyshareholdersandfinanciersshouldcareaboutsalientbenchmarksovercontinuous

measuresofperformanceinthefirstplace.

Consistentwithcatering,managerswith“shorthorizons”areespeciallylikelytomanage

earnings.BergstresserandPhilippon(2006)findthataccrualsmanagementisgreaterincompanies

whoseCEO’scompensation,viastockandoptionsholdings,issensitivetocurrentshareprices.

Sloan(1996)findsthatfirmswithhighaccrualsearnlowsubsequentreturns,whichsuggeststhat

earningsmanagementmaybesuccessfulinboostingshareprice,oratleastinsustaining

overvaluation.Consistentwiththeviewthatmanagersuseearningsmanagementtofoolinvestors

andissueovervaluedequity,Teoh,Welch,andWong(1998a,b)findthatinitialandseasonedequity

issuerunderperformanceisgreatestforfirmsthatmostaggressivelymanagepre‐issueearnings.

Animportantquestioniswhetherearningsmanagementhassignificantconsequencesfor

investment.Graham,Harvey,andRajgopal(2005)presentCFOswithhypotheticalscenariosand

findthat41%ofthemwouldbewillingtopassupapositive‐NPVprojectjusttomeettheanalyst

consensusEPSestimate.Directevidenceofthistypeofvaluelossisdifficulttodocument,but

Jensen(2005)presentsseveralanecdotes,andsuggestiveempiricalstudiesincludeTeohetal.

(1998a,b),EricksonandWang(1999),Bergstresser,Desai,andRauh(2006),andMcNicholsand

47

Stubben(2008).Oneprovocativefindingisthatearningsmanagementactivityincreasespriorto

stockacquisitions.

2.6.3.   Firm names 

Namechangesprovidesomeofthesimplestandmostcolorfulexamplesofcatering.In

frictionlessandefficientmarkets,ofcourse,firmnamesareasirrelevantasdividends.Butthereis

atleastamodestfundamentalcostofchangingnames,andperhapsthroughanamechangeafirm

cancreateasalientassociationwithatemporarilyoverpricedcategoryofstocks.

Evidenceofacateringmotiveforcorporatenamesismostprominentinbubbles.Inthe

1959‐62erawhichMalkiel(1990)referstoasthe“tronicsboom,”firms“oftenincludedsome

garbledversionoftheword‘electronics’intheirtitleevenifthecompanieshadnothingtodowith

theelectronicsindustry”(p.54).SystematicevidencehasbeenassembledfortheInternetbubble.

Cooper,Dimitrov,andRau(2001)findthat147(generallysmall)firmschangedto“dotcom”names

betweenJune1998andJuly1999,asInternetvaluationswererapidlyrising.CateringtoInternet

sentimentdidseemtodeliverashort‐termpriceboost:Cooperetal.reportaremarkablylarge

averageannouncementeffectof74%fortheirmainsample,andanevenlargereffectforthesubset

thathadlittletrueinvolvementwiththeInternet.

Interestingly,Cooperetal.(2005)documentthatnameswerelaterusedtodissociate

companiesfromtheInternetsectorwhenpricescrashed.BetweenAugust2000andSeptember

2001,firmsthatdroppedtheirdotcomnamesawapositiveannouncementeffectofaround70%.

TheeffectwasalmostaslargeforfirmsthatdroppedthedotcomnamebutkeptanInternet

businessfocus,andforthedoubledipperswhichdroppedthenametheyhadnewlyadoptedjusta

fewyearsearlier.

Mutualfundcompaniesalsoappeartobeawareofthepowerthatnameshaveoninvestor

demand.Cooper,Gulen,andRau(2005)findthatfundnamesshiftawayfromstylesthatexperience

48

lowreturnsandtowardthosewithhighreturns.Theauthorsfindthatnamechangesdonotpredict

fundperformance,yetinflowsincreasedramatically,evenforcosmeticnamechangerswhose

underlyinginvestmentstyleremainsconstant.Presumably,then,thenamechangedecisionis

driveninpartbythedesiretoattractfundinflowsandthusincreasethefund’sfeeincome.Indeed,

Cooperetal.findthattheinfloweffectincreaseswhenmoneyisspenttoadvertisethe“new”styles.

2.6.4.  Nominal share prices 

Theaveragesharepricehascenteredaround$25sincetheDepression,asnotedbyDyland

Elliott(2006)andWeld,Benartzi,Michaely,andThaler(2009).Thisisdespiteadramaticdeflation

inthevalueofadollaroverthelastcentury.Inmarketsthatarerisingbecauseofinflationorreal

growth,thisaverageismaintainedbysplits.Weldetal.arguethatstandardexplanationsbasedon

signalingoroptimaltradingranges,whicharemostnaturallythoughtofinrealnotnominalterms,

areunabletoexplaintheconstancyofnominalprices,andseveralotherrelatedfactsaboutactive

sharepricemanagement.Forexample,bothIPOpricesandthesharepricesofopen‐endmutual

fundshavealsoremainedrelativelyconstant.Theyproposeinsteadthatmanagersaresimply

followingnorms,adheringtoanarbitraryhistoricalconventionfromwhichthereisnoparticular

reasontodeviategiveninvestorexpectations.

Weldetal.studythestabilityofstockpricesrelativetothebenchmarkofnoprice

management.Pricesarenotmanagedcontinuously,ofcourse—onaverageandforindividual

stocks,pricesarequitevariablerelativetotheotherextremebenchmarkofaconstantnominal

price.Baker,Greenwood,andWurgler(2009)studynotthestationarityofaveragenominalprices

butwhytheyvarybyafactoroftwoormoreovertime.

Bakeretal.proposethatsharepricesareusedasanothertooltocatertotime‐varying

shareholdersentiment.Inanalogytothedividendpremium,theyforma“low‐pricepremium”as

theaveragemarket‐to‐bookratioofstockswhosepricesfallinthebottomthreedecilesminusthe

49

averageofthosewithpricesinthetopthreedeciles.Theyfindthatwhenexistinglow‐pricefirms

havehighvaluations,morefirmssplit,andthosesplitterssplittolowerprices.IPOsalsomakefora

powerfultest,astheyarefreetolistatalmostanyprice.Consistentwithcatering,IPOs’average

pricesvarycloselywiththelow‐pricepremium.

Thisleavesaquestionofinterpretation.Onederivesfromthestrongcross‐sectional

relationshipbetweenfirmcapitalizationandnominalprice.Ifshareholderstakepriceasshorthand

forsizeorgrowthpotential,firmsmaysplitinorderto“actsmall”whenstocksthataresmallare

especiallyhighlyvalued.Theycannotchangecapitalization,buttheycanchangeshareprice.

2.6.5.   Executive compensation 

Intheframeworkatthebeginningofthissection,weassumedthatmanagershavethe

incentivetocatertoshort‐termmispricing.Onequestioniswhyshareholdersdonotsetup

executivecompensationcontractstoforcemanagerstotakethelongview.25Bolton,Scheinkman,

andXiong(2005)suggestthatshorthorizonsmaybeanequilibriumoutcome.Theystudythe

optimalincentivecompensationcontractforthedynamicspeculativemarketofScheinkmanand

Xiong(2003),inwhichtwogroupsofoverconfidentinvestorstradesharesbackandforthastheir

relativeoptimismfluctuates.Thesharepriceinthismarketcontainsaspeculativeoption

component,reflectingthepossibilitythatnonholdersmightsuddenlybecomewillingtobuyata

highprice.Boltonetal.findthattheoptimalcontractmayinducetheCEOtotakecostlyactionsthat

exacerbatedifferencesofopinion,thusincreasingthevalueoftheoptioncomponentofstockprices,

attheexpenseoflong‐runvalue.

25Aseparatebutrelatedquestionishowmanagerscompensatelower‐levelemployees.BergmanandJenter(2007)arguethatrationalmanagersmayminimizecostsbypayingoptimisticemployeesinovervaluedequity,intheformofoptionsgrants.Benartzi(2001)offersafoundationforthissortofoptimism,showingthatemployeeshaveatendencytoextrapolatepastreturns,andasaconsequenceholdtoomuchcompanystock.SeealsoCoreandGuay(2001)andOyerandSchaefer(2005).

50

3.   Managerial Biases 

Asecondstrandofbehavioralcorporatefinancestudiesthebehaviorofirrationalmanagers

operatinginefficientcapitalmarkets.Byirrationalmanagerialbehaviorwemeanbehaviorthat

departsfromrationalexpectationsandexpectedutilitymaximizationofthemanager.Wearenot

interestedinrationalmoralhazardbehavior,suchasempirebuilding,stealing,orplainslackingoff.

Weareconcernedwithsituationswherethemanagerbelievesthatheisactuallycloseto

maximizingfirmvalue—and,intheprocess,somecompensationscheme—butisinfactdeviating

fromthisideal.26Webeginwithaquickoverviewoftherelevantpsychology,thendevelopasimple

theoreticalframework,andfollowwithareviewofthisliterature.

3.1.  Background on managerial behavior 

Thepsychologyandeconomicsliteraturesrelevanttounderstandingmanagerialbehavior

arevast.Forus,themainthemesarethatindividualsdonotalwaysformbeliefslogically,nordo

theyconvertagivensetofbeliefsintodecisionsinaconsistentandrationalmanner.Theserecall

thedefinitionsofinvestorsentimentandirrationalbehaviorthatareassumedinmarkettimingand

cateringstudies.Followinganoteaboutcorporategovernance,weintroduceandmotivatethe

biasesandnonstandardpreferencesthathavebeeninvestigatedinthecontextofmanagerial

decisions.

3.1.1.   Limited governance 

Forless‐than‐fully‐rationalmanagerstohaveanimpact,corporategovernancemustbe

limitedinitsabilitytoconstrainthemintomakingrationaldecisions.Thisisanalogoustothe

requirementoflimitedarbitrageforthemarkettimingapproach.

26Ourfocusisoncorporatefinance.CamererandMalmendier(2009)discusstheimpactoflessthanfullyrationalbehavioronotherpartsoforganizations.

51

Assuminglimitedgovernanceisnolessreasonablethanassuminglimitedarbitrage.Indeed,

intheUS,asignificantelementofmanagerialdiscretioniscodifiedinthebusinessjudgmentrule.

Takeoverbattlesandproxyfightsarenotoriouslyblunttools.Boardsmaybemoreapartofthe

problemthanthesolutioniftheyhavetheirownbiasesorarepawnsofmanagement.Forinstance,

Gompers,Ishii,andMetrick(2003)findthatfirmsthatelectedpoliciestodiminishshareholder

rightsexperiencelowerstockreturns.Andunlikeinatraditionalagencyproblem,whicharisesout

ofaconflictofinterestbetweenmanagersandoutsideinvestors,standardincentivecontractshave

littleeffect,becauseanirrationalmanagermaywellthinkthatheismaximizingvalue.

Itisobviousfromcasualobservationthattopmanagers“matter,”inthattheyhavethe

powertomakedecisionsthataffectinvestmentandfinancingpolicyandfirmvalue.Thereisalso

systematicevidence.BertrandandSchoar(2003)findthatindividualmanagershaveinvestment

andfinancingstylesandpreferences,possiblyinherentandpossiblybasedonbeliefsshapedby

beliefs,thattheybringfromprevioustonewemployers.Forexample,CEOsthatusebigger

mortgagesfortheirownhomepurchasesalsousemoreleverageintheirfirms(Cronqvist,Makhija,

andYonker(2011)),althoughpartofthiseffectcanbeattributedtoendogenousfirm‐manager

matching.Kaplan,Klebanov,andSorensen(2011)findthatcertainexecutiveabilitycharacteristics

arecorrelatedwithfirmperformance.Asonemightexpect,theexpressionofindividualmanagerial

decisionsisstrongerwhentheCEOispowerfulor,similarly,whengovernanceisweaker(Adams,

Almeida,andFerreira(2005)andCronqvistetal.).

3.1.2.  Bounded rationality 

Perhapsthesimplestdeviationfromthebenchmarkoffullrationalitygoesbythenameof

boundedrationality,introducedbySimon(1955).Boundedrationalityassumesthatsometypeof

cognitiveorinformation‐gatheringcostpreventsagentsfrommakingfullyoptimaldecisions.

Boundedly‐rationalmanagerscopewithcomplexitybyusingrulesofthumbthatensurean

52

acceptablelevelofperformanceand,hopefully,avoidseverebias.Conlisk(1996)reviewstheolder

boundedrationalityliterature;seeGabaix(2011)foramorerecentmodelingapproach.Bounded

rationalityoffersareasonablycompellingmotivationforthefinancialrulesofthumbthatmanagers

commonlyuse.Wenotesomeoftheseandconsiderthedistortionsthattheycreate.

3.1.3.  Optimism, overconfidence and hubris 

Mostresearchinthemanagerialbiasesliteraturehasfocusedontheillusionsofoptimism

andoverconfidence.Illustratingoptimism,Weinstein(1980)findsthatsubjectsbelievethemselves

morelikelythanaveragetoexperiencepositivefuturelifeevents(e.g.owningownhome,living

past80)andlesslikelytoexperiencenegativeevents(beingfired,gettingcancer).Illustrating

overconfidenceinone’sownskills,andpossiblyoptimismaswell,Svenson(1981)findsthat82%

ofasampleofstudentsplacedthemselvesamongthetop30%safestdrivers.

Therearegoodreasonstofocusontheseparticularbiasesinamanagerialsetting.First,

theyarestrongandrobust,havingbeendocumentedinmanysamples,includingsamplesofactual

managers(LarwoodandWhittaker(1977),MarchandShapira(1987),andBen‐David,Graham,and

Harvey(2010)).Second,managerialdecisionstendtobehighlycomplex,asettingwhere

overconfidenceismostpronounced,andidiosyncratic,whichreducesthepotentialfordebiasing

throughlearning(Gervais(2010)).Third,thesebiasesarealsooftenfairlyeasytointegrateinto

existingmodels.Optimismisusuallymodeledasanoverestimateofameanabilityoroutcomeand

overconfidenceasanunderestimateofavariance.Inthisfashionwemodeltheconsequencesof

optimism,below,andalsonotesituationsinwhichanalternativeassumptionofoverconfidence

couldleadtodifferentconclusions.

Finally,overconfidencealsoleadsnaturallytomorerisk‐taking.Evenifthereisno

overconfidenceonaverageinthepopulationofpotentialmanagers,thosethatareoverconfident

aremorelikelytoperformextremelywell(andextremelybadly),placingthemdisproportionately

53

intheranksofupper(andformer)management.Andevenifanindividualmanagerisbornwithout

bias,anattributionbias—thetendencytotakegreaterresponsibilityforsuccessthanfailure(e.g.,

LangerandRoth(1975))—mayleadsuccessfulmanagerstobecomeoverconfident,asmodeledin

GervaisandOdean(2001).

3.1.4.  More on reference dependence 

Referencepointsandanchoringareequallycompellingpsychologicalfoundations,when

comparedtooverconfidence,andoffersomeempiricaladvantagesinidentifyingbehavioraleffects

incorporatefinance.Section2.1describesthepsychologicalunderpinningsofreferencepointsand

anchoring.Theseholdspecialinterestwithinafirm.Afirmiscollectionofimplicitandexplicit

contractsbetweenmanagersandemployees,thefirmanditscustomers,creditors,underwriters,

shareholders,andotherstakeholders.Itisnaturaltothinkoftheseasformingreferencepointsin

negotiations,anddeterminingexpostthesatisfactionofthevariousparties.Forexample,whether

themanagementissatisfiedwiththeperformanceofitsunderwritersdependsontheir

performancerelativetoareferenceprice.Whethershareholdersaresatisfiedwithamergeroffer

dependsonthepricerelativetorecenttransactionprices;wewillseespecificevidenceofthislater.

Hart(2008)usesreferencepointsmorebroadlyastheunderpinningforatheoryofthe

firm.Usingcontractsasreferencepointstowhichpartiesfeelentitledisasubstituteforthe

assumptionsofincompletecontractsandexpostbargainingoverthesurplusthatdrivetheresults

inGrossmanandHart(1986)andHartandMoore(1990).Becausewedonotobservethissortof

bargainingwithinrealfirms,thereferencepointapproachmayoutlivetheexistingarchitectureof

thepropertyrightstheoryofthefirm.Sofar,however,muchoftheempiricalevidenceisfocusedon

narrowerapplicationsofreferencepointpreferences.

54

Forthemoment,weuseoverconfidence,insteadofreferencepoints,asanexampleofan

organizingframeworkinthenextsection.Thesectiononbehavioralsignalingattheendofthe

surveywilldevelopamodelusingreferencepoints.

3.2.   Theoretical framework 

ThederivationbelowisinthespiritofHeaton(2002)andMalmendierandTate(2005),

modifiedtomatchthenotationinthemarkettimingandcateringmodelasmuchaspossible.We

assumethemanagerisoptimisticaboutthevalueofthefirm’sassetsandinvestmentopportunities.

Hebalancestwoconflictinggoals.Thefirstistomaximizeperceivedfundamentalvalue.Tocapture

this,weaugmentfundamentalvaluewithanoptimismparameter,

KKf ,1 ,

wherefisincreasingandconcaveinnewinvestmentK.Notethathere,themanagerisoptimistic

aboutboththeassetsinplace(fcanincludeaconstantterm)andnewopportunities.Onceagain,if

traditionalmarketimperfectionscausetheModiglianiandMiller(1958)theoremtofail,financing

mayenterfalongsideinvestment.

Themanager’ssecondconcernistominimizetheperceivedcostofcapital.Weassumehere

thatthemanageractsonbehalfofexistinginvestors,becauseofhisownstakeinthefirmand

fiduciaryduty.ThisleadstoasimilarsetuptothemarkettimingobjectiveinSection2.2,exceptthat

anoptimisticmanagerneverbelievesthereisagoodtimetoissueequity.Inparticular,sincethe

capitalmarketisefficientandvaluesthefirmatitstruefundamentalvalueoff‐K,themanager

believesthatthefirmisundervaluedbyf,andthusinsellingafractionofthefirmeheperceives

thatexisting,long‐runshareholderswilllose

,Kfe .

55

Puttingthetwoconcernstogether,theoptimisticmanagerchoosesnewinvestmentand

financingtosolve

,,1max,

KfeKKfeK

.

Wedonotexplicitlyincludeabudgetconstraint.Instead,againtokeepthenotationsimple,we

consideritsreduced‐formimpactonf.

DifferentiatingwithrespecttoKandegivestheoptimalinvestmentandfinancialpolicyof

anoptimisticmanageroperatinginefficientcapitalmarkets:

eKf K

11

1, ,and

,,,1 KefKfKf ee .

Thefirstconditionisaboutinvestmentpolicy.Insteadofsettingthemarginalvaluecreated

frominvestmentequaltothetruecostofcapital,normalizedtobeonehere,managersoverinvest,

tothepointwherethemarginalvaluecreationislessthanone.Themoreoptimistic()isthe

managerandthelessequity(e)heisforcedtoraiseinfinancinginvestment,thegreaterthe

problem.Totheextentthatthemanagerhastoraisecapitalbyissuingequity,thecostofcapitalis

scaledupbythesamefactorasthemanager’sover‐optimismscalesupthemarginalproductof

capital,soraisingequityoffsetsthedistortionininvestmentcausedbyover‐optimism.If100%of

thecapitalisraisedbyissuingequity,forexample,investmentisfirst‐best.Thesecondconditionis

aboutfinancing.Themarginalvaluelostfromshiftingthefirm’scurrentcapitalstructureaway

fromequityisweighedagainsttheperceivedmarkettiminglosses.Asintheanalysisofirrational

investors,weconsidersomespecialcases.

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Investmentpolicy.Ifthereisnooptimalcapitalstructure,sothatfeisequaltozero,the

managerwillnotissueequity,settingetozero,andthereisnointeractionamongfinancing,

internalfunds,andinvestment.Inthiscase,theoptimisticmanagerwillclearlyoverinvest:fKisless

thanunity.InHeaton(2002)andMalmendierandTate(2005),thereisanoptimalcapitalstructure,

ormorepreciselyanupperboundondebt.Ifthemanagerneedsequitytoinvest(here,fegreater

thanzero),thedegreeofoverinvestmentfalls.

Needingequityisakintohavinglittlecashorcashflowavailableforinvestment.Thusin

thissetup,investmentcanbestronglyrelatedtocurrentcashflowandprofits,controllingfor

investmentopportunities.ThisleadstoabehavioralfoundationfortheJensen(1986)agencycosts

offreecashflow.Butinsteadofreceivingprivatebenefitsofcontrol,managersaresimply

optimisticandoverinvestfromcurrentresourcesasaresult.Leveragereducesthedegreeof

overinvestmentbyincreasingfe,therebyincreasingequityissueseandreducingK.

Inamorecomplexspecification,theseconclusionsmaychange.Onemighthavethe

manageroptimisticonlyaboutassetsinplace,inwhichcasethereisnooverinvestment,andthere

willtypicallybeunderinvestmentasafirmapproachesitsdebtcapacity.Also,itisworth

emphasizingthatweareexaminingoptimisminisolationhere.Layeringonotherimperfections,

suchasriskaversion,maymeanthatoptimismmovesinvestmentfromaninefficientlylowlevel

towardthefirstbest,asinGervais,Heaton,andOdean(2010)andGoelandThakor(2002).Wewill

revisitsomeoftheseinteractionswhenwediscussexecutivecompensation.Hackbarth(2009)

discussesanothersettinginwhichmultiplebiasescanworkinopposition,arguingthatthe

combinationofmanagerialoptimismandoverconfidencecanreducetheunderinvestmentdueto

debtoverhang(Myers(1977)).

Financialpolicy.Anoptimisticmanagerneversellsequityunlesshehasto.Ifthereisan

upperboundonleverage(fegreaterthanzero,here),optimismpredictsapeckingorderof

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financingdecisions:Themanagerreliesoninternalcapitalanddebtandusesoutsideequityonlyas

alastresort.Again,otherimperfectionsmaymitigatetheaversiontoequity.Ifthemanagerisrisk

aversewithanundiversifiedpositioninthefirm’sequity,forexample,hemaywishtoissueequity

eventhoughitisbelowwhathethinksittobeworth.

Managerialoverconfidencecanhavedifferenteffectsoncapitalstructurethanoptimism,

Hackbarth(2009)argues.Ifoverconfidenceismodeledasunderestimatingtheriskofearnings,

managersmayviewtheirdebtasundervaluedandtooexpensiveasasourceofcapital.The

convexityofequity,ontheotherhand,leadsmanagerstoviewtheirequityasovervalued.This

reversesthepeckingorderthatobtainsunderoptimism.Sufficetosaythattheoreticalpredictions

abouttheeffectofoptimismandoverconfidenceoncapitalstructurearesomewhatsensitivetothe

modelingframework.

Othercorporatedecisions.Itisnotaseasytoincorporateotherdecisionsintothis

framework.Considerdividendpolicy.Ifthemanagerismoreoptimisticaboutfuturecashflowand

assetsinplacethanoutsideinvestors,hemightviewadividendpaymentasmoresustainable.On

theotherhand,ifheviewsfutureinvestmentopportunities,andhencefundingrequirements,as

greater,hemightbereluctanttoinitiateorincreasedividendsandretaininternalfundsinstead.

Thisanalysisrequiresamoredynamicmodelofinvestmentandcashflowandadecompositionof

firmvalueintoassetsinplaceandgrowthopportunities.

3.3.   Empirical challenges 

Ifthemainobstacletotestingtheirrationalinvestorsapproachisfindingaproxyfor

misvaluation,thechallengehereistoidentifyoptimism,overconfidence,orthebehavioralbiasof

interest.Withoutanempiricalmeasure,theirrationalmanagersapproachistypicallydifficultto

distinguishfromstandardagencytheory.Thatis,inStein(2003),anempire‐buildingmanagerwill

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ecKKfeK

1max,

,

wherereflectsthepreferenceforortheprivatebenefitsthatcomewithpresidingoveralarger

firm,asinJensenandMeckling(1976)orGrossmanandHart(1988),ratherthanoptimism.

Rationalinvestorsrecognizetheagencyproblemupfront,socreflectsthecostofraisingoutside

equity,andmanagementandexistingshareholdersbeartheagencycosts.

Thisreducedformisalmostidenticaltotheobjectivefunctionofanoptimisticmanager.

Bothcangenerateoverinvestment,underinvestment,cashflow‐investmentsensitivities,pecking

orderfinancing,andsoforth.Moreover,Steinpointsoutthattheagencymodelisitselfhardto

distinguishfrommodelsofcostlyexternalfinancebuiltonasymmetricinformation.Thus,totest

thebehavioraltheories,onemustseparatetherelatedtooverconfidenceandoptimismfromthe

thatarisesfromagencyorasymmetricinformationproblems.

3.4.   Investment policy 

Despitethedifficultyofobtainingdirect,manager‐levelmeasuresofoptimismand

overconfidence,evidenceisaccumulatingthatthesebiasesdoaffectbusinessinvestment.

3.4.1.   Real investment 

Theevidencedoessuggestthatentrepreneurialstartupsareoftenmadeunderahaloof

overconfidenceandoptimism.Cooper,Woo,andDunkelberg(1998)findthat68%of

entrepreneursthinkthattheirstartupismorelikelytosucceedthancomparableenterprises,while

only5%believethattheiroddsareworse,andathirdofentrepreneursviewtheirsuccessasallbut

guaranteed.ThesurveyofFrenchentrepreneursbyLandierandThesmar(2009)givesthesame

message:Atstartup,56%expect“development”inthenearfuturewhileonly6%expect“difficulty.”

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Theactualperformanceofstartupinvestmentsismoresobering.LandierandThesmarfind

thatwhensurveyedthreeyearsintotheirendeavor,only38%ofFrenchentrepreneursexpect

further“development”while17%anticipate“difficulty.”Leavingprofitabilityasideentirely,only

halfofallstartupssurvivemorethanthreeyears(Scarpetta,Hemmings,Tressel,andWoo(2002)).

MoskowitzandVissing‐Jorgensen(2002)arguemoregenerallythatthereturnonprivateequityin

theUSbetween1952and1999islowerthanseemsjustifiedgiventheundiversifiednatureof

entrepreneurialinvestment.Asawhole,theevidenceonstartupinvestmentsseemsconsistentwith

theoverconfidencethatCamererandLovallo’s(1999)experimentalsubjectsdisplaywhenmaking

entrydecisions.

Optimismalsomayinfluenceinvestmentinmorematurefirms.Merrow,Phillips,andMyers

(1981)compareforecastandactualconstructioncostsforpioneerprocessplantsintheenergy

industry.Thereisastrongoptimismbiasinprojectcostforecasts,withactualcoststypicallymore

thandoubletheinitialestimates.StatmanandTyebjee(1985)surveyseveralotherstudiesofthis

sort,involvingmilitaryhardware,drugs,chemicals,andotherdevelopmentprojects,andconclude

thatoptimisticbiasesincostandsalesforecastsarefairlywidespread.

MalmendierandTate(2005)performcross‐sectionaltestsoftheeffectsofoptimismon

investment.Theyformamanager‐levelproxyforoptimismbasedonthepropensityforamanager

tovoluntarilyholdin‐the‐moneystockoptionsinhisownfirm.Theirintuitionisthatsincethe

CEO’shumancapitalisalreadysoexposedtofirm‐specificrisk,voluntarilyholdingin‐the‐money

optionsisastrongvoteofoptimism.27UsingthisoptimismproxyforalargesampleofUSfirms

27MalmendierandTatefindthatthepropensitytovoluntarilyretainin‐the‐moneyoptionsisnotsignificantlyrelatedtofutureabnormalstockreturns,supportingtheirassumptionthatsuchbehaviorindeedreflectsoptimismratherthangenuineinsideinformation.SenandTumarkin(2010)modeltheCEO’sportfoliochoiceandoptionexerciseprobleminmoredetailandarguethatamorerobustmeasureofoptimismissimplywhethertheCEOsellsorretainsthesharesreceiveduponexercise.SeeGiderandHackbarth(2010)foranoverviewofoptimismandoverconfidenceproxies.

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between1980and1994,MalmendierandTatefindthatthesensitivityofinvestmenttocashflowis

higherforthemoreoptimisticCEOs.ItisespeciallyhighforoptimisticCEOsinequity‐dependent

firms,thatis,insituationswhereperceivedfinancialconstraintsaremostbinding.Theirresults

supportthepredictionsofthebasicoptimismmodel.

Ben‐David,Graham,andHarvey(2010)testwhethersurvey‐basedmeasuresof

overconfidenceandoptimismhelptoexplainthelevelofinvestmentasopposedtoitssensitivityto

cashflow.Theyaskfinancialexecutivestoestimatethemeanandvarianceoftheirfirm’sstock

return.Thisallowsthemtoformseparateoptimismandoverconfidencemeasures.Astrikingresult

isthatfinancialexecutivesare,indeed,extremelyoverconfident:theirsubjective80%confidence

intervalsaboutthefirm’sone‐yearstockreturncontainstherealizedreturnonly33%ofthetime.

Theyalsoconnectthesemeasurestothelevelofinvestment,andfindthatbothoptimismand

overconfidenceareassociatedwithhigherinvestment.

Onecategoryofinvestmentthatwouldseemparticularlyinvitingtooverconfident

managersisresearchanddevelopment,wherethepayoffisinherentlyquiteuncertain.Hirshleifer,

Low,andTeoh(2010)findthatoverconfidentmanagers—measuredusingoptions‐basedproxies,

asabove,andthecharacterofdescriptionsoftheCEOinthepress,similartoMalmendierandTate

(2004)—investmoreinR&Dandtranslatethistohigherpatentandpatentcitationcount.Atthe

sametime,thereislittlerelationshipbetweentheiroverconfidencemeasuresandfinancialorstock

marketperformance.

Inadditiontotheevidenceabove,keepinmindthatoptimism,asdiscussedearlier,shares

manypredictionswithmoreestablishedtheories,andthusisacandidatetoexplainvariousearlier

results.Forexample,thefactthatmanagersinvestratherthanpayoutcashwindfalls(Blanchard,

LopezdeSilanes,andShleifer(1994))lookslikeamoralhazardproblem,butisalsoconsistentwith

optimism.Likewise,someinvestmentpatternsthatlooklikeadverse‐selection‐drivencostly

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externalfinancemaysimplyreflectamistakenmanagerialbeliefthatexternalfinanceiscostlier.A

possibleexampleisthehigherinvestment‐cashflowsensitivitiesofyoungerentrepreneurialfirms

(Schaller(1993)),whichasnotedaboveappeartoberunbyespecialoptimists.

Movingawayfromoptimismandoverconfidence,a“bias”ofboundedrationalityappearsto

beaplausibleexplanationforsomecommoncapitalbudgetingcriteria.Forexample,whilethenet

presentvaluecriterionistheoptimalcapitalbudgetingrule(inefficientmarkets),realmanagers

tendtoemploysimplerrules.Surveyingpracticeinthe1970s,GitmanandForrester(1977)find

thatlessthan10%of103largefirmsuseNPVastheirprimarytechnique,whileover50%usethe

IRRrule,whichavoidsacostofcapitalcalculation.TheGrahamandHarvey(2001)surveyofCFOs

alsofindsthattheIRRruleismorewidelyusedthanNPV.Over50%ofCFOsactuallyusethe

paybackperiodrule,anevenlesssophisticatedrulethatrequiresneitheracostofcapitalinputnor

cashflowforecastsbeyondacutoffdate.

GrahamandHarveyalsofindthatamongmanagerswhodouseadiscountingprocedure

tendtoapplyafirm‐widediscountrateratherthanaproject‐specificrate,againincontrastto

normativeprinciples.28Kruger,Landier,andThesmar(2011)suggestthatthispracticeintroduces

significantinvestmentdistortions.Takingtheproject‐specificCapitalAssetPricingModelasa

normativebenchmark,Krugeretal.pointoutthatmultidivisionfirmsthatsimplyapplyaweighted‐

averagediscountratetoallprojectswilloverinvestinhighbetadivisionsandunderinvestinlow

betadivisions.Consistentwiththisprediction,theydocumentthatdivision‐levelinvestmentis

positivelyrelatedtothespreadbetweenthedivision’smarketbetaandthefirm’saveragebeta.

28Agoodquestioniswhethertheuseofsuchrulesisbetterunderstoodasanagencyproblemthanasboundedrationality.Thatis,executivesmightusesimplerulestoshortentheworkdayandsavetimeforgolf.However,GrahamandHarveyfindthathigh‐ownershipmanagersareifanythinglesslikelytouseNPVandmorelikelytousethepaybackperiodrule.

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Lossaversionhasalsoappearedasanexplanationforcertaininvestmentpatterns,suchas

inthewidelyasserted,butlessdocumented,managerialpropensityto“throwgoodmoneyafter

bad.”Suchbehaviorismostrelevantforustotheextentthatitreflectssomethingmorethan

rationalcareerconcerns,e.g.asituationwherethemanagertriestodistorttheupdatingprocessto

maintainhighcompensation.Shefrin(2001)offersseveralanecdotesconcerningmajorcorporate

investmentsthathavetheflavorofgoodmoneyafterbad.StatmanandSepe(1989)findthatthe

marketreactiontotheterminationofhistoricallyunprofitableinvestmentprojectsispositive,

suggestingthatinvestorsrecognizethatexecutiveshaveatendencytocontinuepoorprojects.

RelatedevidencecomesfromtheGuedjandScharfstein(2008)studyofdrugdevelopment

decisions.Theyfindthatsingle‐productearlystagefirmsappearhighlyreluctanttoabandontheir

onlyviabledrugcandidates,evenwhentheresultsofclinicaltrialsarelessthanpromising.Some

combinationofagency,managerialoptimism,andagambling‐to‐get‐back‐to‐evenattitudeseems

likeaplausibleexplanationfortheseresults.

3.4.2.   Mergers and acquisitions 

Inaseminalcontributiontobehavioralcorporatefinance,Roll(1986)outlinesahubris‐

basedtheoryofacquisitions.Hesuggeststhatsuccessfulacquirersmaybeoptimisticand

overconfidentintheirownvaluationofdealsynergies,andfailtoproperlyaccountforthewinner’s

curse.Rollinterpretstheevidenceonmergerannouncementeffects,surveyedbyJensenand

Ruback(1983),Andrade,Mitchell,andStafford(2001),andMoeller,SchlingemannandStulz

(2005),aswellasthelackofevidenceoffundamentalvaluecreationthroughmergers,asconsistent

withthistheory.

MalmendierandTate(2004)developthisargumentandusetheiroptions‐basedproxyfor

CEOoptimismtotestit.Theyfindpatternsconsistentwithoptimismandoverconfidence.First,

optimisticCEOscompletemoremergers,especiallydiversifyingmergers,typicallysuggestedas

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beingofdubiousvalue.Second,optimismhasitsbiggesteffectamongtheleastequitydependent

firms—whenmanagersdonothavetoweighthemergeragainstanequityissuethatthey,as

optimists,wouldperceiveasundervalued.Third,investorsaremoreskepticalaboutbid

announcementswhentheyaremadebyoptimisticCEOs.SchneiderandSpalt(2010)findsimilar

results,includingthatofferpricesarehigher,butacquirerannouncementreturnsarelower,when

thetargethas(had)skewedreturns.Theannouncementreturnsevidenceisconsistentwiththe

themeofirrationalmanagersoperatinginefficientmarkets.29

ManagerialbiasesresearchhastakenaFreudianturnwithAktas,deBodt,Bollaert,and

Roll’s(2010)studyofCEOnarcissism.Theymeasurenarcissism,atraitrelatedtobutdistinctfrom

overconfidence,astheratiooffirstpersonsingularpronounstototalfirstpersonpronounsusedin

CEOs’transcribedspeeches.Thusly‐definednarcissistCEOsaremorelikelytobeacquirers,and

morelikelytohaveinitiatedtheirtransactions.Thisisinterpretedasconsistentwiththehigh‐

stakesactivityrequiredtomaintainthenarcissisticego.Targetsrunbynarcissists,meanwhile,

securehigherbidpremia.Aktasetal.speculatethatthisarisesbecausenarcissisticCEOsdemand

extracompensationforthelossofegoassociatedwithlosingcontrol.

Ifmanagerialbiasesaffectdecisionsbecausegovernanceislimited,cross‐sectionalvariation

ingovernancemaybeusefulforidentifyingtheeffect.Yermack(1996)findsthatfirmswithsmaller

boardsofdirectorshavehigherfirmvalue;KolasinskiandLi(2010)findthatsmallboards

dominatedbyindependentdirectorsreducetheimpactofCEOoverconfidenceonacquisition

frequency.TheyusenegativefuturereturnsonCEOpurchasesasexpostevidenceofexante

overconfidence.

29Formoreanecdotalevidenceontheroleofhubrisintakeovers,seeHietala,Kaplan,andRobinson(2003)andShefrin(2000,chapter16).

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Tobeusefulinempiricalwork,thesegovernancemechanismsneedtobeexogenous.

Unfortunately,asHermalinandWeisbach(2003)andHarrisandRaviv(2008)pointout,theseare

typicallyendogenoustofirmperformance.Nonetheless,thepredictionsherearetypically

concerningcoefficientsoninteractionterms,sotheendogeneityproblemcouldbemitigated.

Referencepointthinking,inparticularinvolvingtheofferprice,alsoplaysaroleinmerger

activity.Anoffermustbemadeatapremiumtothetarget’scurrentprice,andthemostsalientand

specificsuchpricesarerecentpeaks,suchasthetarget’s52‐weekhigh.Thereareanumberofways

suchsalientbuteconomicallyunremarkablepricescouldenterthepsychologyofmerger

negotiations.Valuingacompanyisasubjectivetask,andvaluingacombinationisdoublyso.One

couldeasilyimaginethatrecentpeakpricesserveasanchorsinsuchcalculationsonboththe

bidderandthetargetside.Thetargetmayusepeakpricesasastartingpointfornegotiations.Or,

targetshareholdersmayresistsellingata“loss”toarecentpeak,akintoadispositioneffect.30

Baker,Pan,andWurgler(2011)findthatdealparticipantsdoindeedfocusonrecentprice

peaks.Thereisaspikeinthedistributionofofferpricesatthetarget’s52‐weekhighandother

historicalpeaks.Bidding‐firmshareholdersreactnegativelytothecomponentoftheofferpricethat

isdrivenbythe52‐weekhigh,whichsuggeststhattheyrationallyviewthisportionas

overpayment.Theprobabilitythatanoffergoesthroughincreasesdiscontinuouslywhentheoffer

exceedsthe52‐weekhigh.Thisisanimportantresultinthatitrepresentsunusuallycleanevidence

oftherealeffectsofbehavioralcorporatefinance.

Finally,Bakeretal.findthatreferencepointthinkingmayhelptoexplainwhymergersand

stockmarketvaluationsarepositivelycorrelated:theofferpremiumrequiredtoexceedarecent

pricepeakissmallerwhenvaluationshaveincreased.Conversely,whenvaluationshave

30Notethatwhilesomeoftheseeffectsinvolvemanagerialbiases,othersrepresentinvestorbiasesandthustheevidencebelowcouldalsobeincludedinourearliersectionsaboutinvestorirrationality.

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plummeted,targetsmayfailtoadjustfrompriorpeakanchorsand,asaresult,askforvaluations

thataresimplyimplausibletobidders.

3.5.   Financial policy 

Thereisagrowingbodyofevidencethatmanagerialbiasesaffectfinancingpatterns.

Existingworkaddressesthetimingandpricingofequityissues,featuresofIPOs,capitalstructure

anddividendpolicy,andfinancialcontracting.Referencedependenceplaysaprominentrolein

thesestudies.

3.5.1.  Equity issues 

DoestheCEOdriveafirm’sstockreturns?Ifso,thenaCEOwouldrightlybeproud,and

shareholdersshouldtakenotice,whenshehascreatedvalueandraisedthesharepriceabovethe

levelthatprevailedwhenshetookthehelm.Ifnot,forexampleifsharepricesaredominatedby

aggregatemoves,thenthathistoricalpricedoesnotserveasaparticularlymeaningfulreference

pointforCEO‐specificvaluecreation.

BakerandXuan(2011)findevidencethatCEO‐specificsharepriceperformancedoes

indeedaffectfinancingactivity.Equityissuanceisresponsivetorecentstockreturns,but

considerablymoresowhentheyoccurduringthecurrentCEO’stenure.Inparticular,the

probabilityofequityissuanceinafollow‐onofferingincreasesdiscontinuouslywhentheshare

priceexceedstheinheritedprice.

Apparently,somemarketparticipantsinvolvedinequityissuanceattribute“valuecreation”

totheCEOandherteam.Tobeclear,thisbyitselfisnotnecessarilyabehavioralphenomenon;the

intriguingresultistheeffectoftheinheritedsharepriceleveleventhoughsubsequentmarket‐level

movementsbeyondtheCEO’scontrolcomplicatetheattributionofvaluecreation.Theattribution

errorcouldbeontheinvestorside,withmanagementhavingtowaituntilthispointinorderto

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convinceinvestorsthatissuetermswereappealing.Insteadofthateffect,orinadditiontoit,the

managementteammayviewcrossingtheinheritedpricethresholdasanopportunitytotimethe

equitymarket.

3.5.2.  IPO prices 

IPOunderpricingcanalsobeunderstoodfromtheperspectiveofreference‐point

managerialpreferences.LoughranandRitter(2002)developanexplanationthatcombines

reference‐pointpreferencesandmentalaccounting(Thaler(1980,1985)).Animportantfacetof

IPOpricingisthattheinvestmentbankersunderwritingtheofferingformaninitialfilepricerange,

astheyshopthedealtoinstitutionalinvestors.Ifdemandforthenewsharesishigh,thebankers

willpricetheofferingatthehighendofthisrange.Ifitislow,theywillpricetheofferingatthe

midpoint,orsometimeslower.Onthefirstday,pricesareamarketoutcomeofthenewsupplyand

demand.

LoughranandRitterassumethatissuingmanagersmentallyaccountfortwoquantitiesin

judginganoffering’ssuccess:the(perceived)gainfromthegapbetweenthefirstdayclosingprice

andanaturalreferencepoint,themidpointofthefilepricerange;andthe(real)lossfromthe

dilutiveeffectoftheunderpricing.Ifthegainisjudgedtooutweightheloss,whereeachisevaluated

separatelywiththeprospecttheoryvaluefunction,theexecutivesaresatisfied.Intuitively,they

maybetoooverwhelmedbythe“windfallgain”tocomplainmuchaboutunderpricing.31

Thissetupisdesigned,inpart,toexplainthepatternthatunderpricingisgreaterwhenthe

offerpriceisabovetheinitialfilepricerange.LoughranandRitter(2002)findthatinissueswhere

theofferpriceisbelowtheminimumofthefilepricerange,first‐dayreturnsarearelativelysmall

31LoughranandRitterassumethattheunderwriterprefersunderpricing,perhapsbecauseitgeneratesprofitablerent‐seekingactivitiesamonginvestors,e.g.tradingwiththeunderwriter’sbrokeragearm,orbecauseitreducesmarketingcosts.

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4%,onaverage,whilethosepricedabovethemaximumhaveaveragefirst‐dayreturnsof32%.This

isconsistentwithissuersacquiescinginsevereunderpricingonlywhentheyaresimultaneously

gettinggoodnewsintheformofupwardrevisionsfromthefilingrange.32

LjungqvistandWilhelm(2005)testsomeofthebehavioralunderpinningsoftheLoughran

andRitterview.UsingdataontheownershipstakesofexecutivesinIPOfirms,theycrudelyproxy

fortheproposednotionofissuersatisfactionbytakingthedollaramountofexecutives’perceived

“gain”fromrevisionsfromthemidpointofthefilepricerangeandsubtractingthedollaramountof

dilutionduetounderpricing.Theyfindthatexecutiveteamsthataremore“satisfied”withtheir

IPOsbythiscriterionaremorelikelytousethesameunderwriterforseasonedofferings,andto

payhigherfeesforthosetransactions.

3.5.3.   Raising debt 

Borrowersandlendersusepasttermsasanchorsorreferencepointsforcurrentterms.

Dougal,Engelberg,Parsons,andVanWesep(2011)findthatthenominallevelofhistorical

borrowingcostsexertsastronginfluenceonthetimetcostofdebt,controllingforavarietyoftime

tborrowercharacteristics.Theeffectappearsforallcreditratingcategories.Forexample,firms

thattookoutcreditfromabankingsyndicatebetween2005and2007sawtheinfluenceofthe

2008financialcrisishaveamutedimpactontheir2008borrowingcostsfromthesamesource.For

firmswhosecreditratingremainedconstantoverthisperiod,one‐thirdreceivedexactlythesame

borrowingratesasinthepre‐crisisperiod.Comparablefirmsthathadn’testablishedsuchanchor

termssawhigherborrowingcosts.

32SeeBenvenisteandSpindt(1989)foranalternativeexplanationforthisasymmetrybasedoninformationgatheringinthebook‐buildingprocess,andEdelenandKadlec(2003)foronebasedonsampletruncationbiasrelatedtothewithdrawlofIPOswhoseprospectsdeteriorateduringthewaitingperiod.

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Itiseasytounderstandhowpriortermsarenaturalstartingpointsforthinkingaboutand

negotiatingnewterms.Theneedforafixedstartingpointcouldbeparticularlyhighinperiodsof

dramaticchangeinthefinancialenvironment.Dougaletal.findadditionalpatternsthatfurthertie

theirresultstoanchoring:specificmanagersandbankersappeartoformrelationshipsthatare

mostaffectedbythebias;whenafirmchangesleadbanks,theeffectofpasttermsdeteriorates;

and,whenafirmchangesCEOorCFO,theeffectofpasttermsdeteriorates.33

Similartohowreferencepointpricesaffectmergeractivityormanager‐specificreference

pointpricesonequityissues,thisexperimentprovidesfurtherevidencethathighlysophisticated

actors—inthiscase,managers,bankers,andinvestorsjointly—areunableto“integrateout”the

past.Futureresearchmaybetteridentifytherealeffectsofthis.Anaturalhypothesis,forexample,

isthatborrowerswhoarebeingofferedadealbecauseofthehappenstanceoffavorablepastterms

willraisemoreandinvestmore.

3.5.4.   Capital structure 

Themostbasicoptimismmodelpredictsapeckingorderfinancingpolicy,aspointedoutby

Heaton(2002).Thus,muchoftheexistingevidenceofpecking‐orderpolicies,fromDonaldson

(1961)toFamaandFrench(2002),isatfacevalueequallyconsistentwithpervasivemanagerial

optimism.Andthenotionofpervasivemanagerialoptimismdoesnotseemfarfetched.InGraham’s

(1999)survey,almosttwo‐thirdsofCFOsstatetheirstockisundervaluedwhileonlythreepercent

stateitisovervalued.Suchresponsesareallthemorestrikinggiventhatthesurveywastaken

shortlybeforetheInternetcrash.

Todistinguishoptimismfromotherexplanationsofpeckingorderbehavior,suchas

adverseselectionasinMyersandMajluf(1984),anaturaltestwouldusecross‐sectionalvariation

33Theauthorsarguethatcostlyrenegotiationoftermscannotexplaintheseresults.

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inmeasuredoptimismtoseewhethersuchbehaviorismoreprevalentinfirmsrunbyoptimists.To

ourknowledge,exactlythistesthasnotbeenconducted,butcertainresultsinMalmendierandTate

(2004,2005)havearelatedflavor.First,andasnotedabove,firmsrunbyoptimists(asidentified

bytheiroptions‐basedproxiesforoptimism)displayahighersensitivityofinvestmenttointernal

cashflow.Second,managersclassifiedasoptimisticshowadifferentiallyhigherpropensitytomake

acquisitionswhentheyarenotdependentonexternalequity.

Boundedrationalityalsomakesanappearanceinfinancialpolicyintheformoftheuseof

simpletargetsforcapitalstructuresandpayouts.GrahamandHarvey(2001)findthat10%ofthe

CFOsintheirsampleusea“verystrict”targetdebt‐equityratioand34%usea“somewhattight”

targetorrange.Suchleveragetargetsaretypicallydefinedintermsofbookvaluesofequityand

debt,andWelch(2004)confirmsthatmarketleverageislargelyallowedtofloatwithstockprices.

Whetherthisisaruleofthumb,aboundedlyrationalfocusonslowermovingbookvalues,ora

rationalrecognitionthatbookvaluesareabetterproxyforliquidationvaluethanmarketvalueis

hardtoprove.Likewise,andasmentionedbefore,Lintner’s(1956)fieldinterviewsrevealasetof

commonrulesofthumbinpayoutpolicythatleadtoareasonablyaccurateempiricalspecification

fordividends.Brav,Graham,Harvey,andMichaely(2005)findthatsomeoftheserulesstillapply

fiftyyearslater.

3.5.5.   Contracting and executive compensation 

LandierandThesmar(2009)examinefinancialcontractingbetweenrationalinvestorsand

optimisticentrepreneurs.34Theyhighlighttwoaspectsofcontractingwithoptimists.First,because

optimiststendtoinefficientlypersistintheirinitialbusinessplan,theoptimalcontracttransfers

controlwhenchangesarenecessary.(KaplanandStromberg(2003)findthatcontingenttransfers

34ManoveandPadilla(1999)alsoconsiderhowbanksseparateoptimistsandrealists.Theyfocusontheoverallefficiencyofthecreditmarket.

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ofcontrolarecommonfeaturesofventurecapitalcontracts.)Second,becauseoptimistsbelieve

goodstatestobemorelikely,theyarewillingtotradesomecontrolandownershiprightsinbad

statesforgreaterclaimsingoodones;inthissense,theoptimalcontract“paystheentrepreneur

withdreams.”Ultimately,optimistsmayself‐selectintoshort‐termdebt,asittransferspayments

andcontroltotheinvestorinstatesthattheythinkareunlikely,whilerealisticentrepreneurs

preferlessriskylong‐termdebt.

LandierandThesmarfindsomeempiricalevidenceofthisseparationindataonFrench

entrepreneurs.Amongotherresults,theyfindthattheuseofshort‐termdebtispositivelyrelated

toanexpostmeasureofoptimisticexpectations,thedifferencebetweenrealizedgrowthandinitial

growthexpectations.Theyalsofindthattheuseofshort‐termdebtispositivelyrelatedto

psychologically‐motivatedinstrumentsforexpectations,suchasregionalsunlightexposureand

ratesofmentaldepression.

Somerelatedphenomenaappearinthecontextofbiasedexecutives’compensation

contracts.StandardcontractingmodelsseemunabletoexplainbasicaspectsofCEOcompensation.

Forexample,HallandMurphy(2002)andDittmanandMaug(2007)pointoutthatconvex

incentivesarecommonlyinducedthroughstockoptions.Yettheseturnouttobehardtocalibrate

tostandardmodelswithrisk‐neutralshareholdersandrisk‐averse,undiversifiedexecutives.

DittmanandMaugarguethatsuchsetupsactuallytendtopredictnegativebasesalaries.

Gervais,Heaton,andOdean(2010)derivetheoptimalcompensationcontractforarisk‐

aversebutoverconfidentmanager.Themanageroverweightshisprivateinformation,sothe

optimalcontractbalancesthestandardissueofovercominghisriskaversionwiththeneedtoavoid

rashinvestments.Themostbasiceffectisthatifthemanagerishighlyoverconfident,shareholders’

wealth‐maximizingcontractishighlyconvex,becausethemanagerovervaluesit.Thiseffectis

reminiscentofpayingwithdreams.

71

Theprospecttheoryvaluefunctionprovidesanotherexplanationforstockoptionsand

positivebasesalariesasoptimalcontracts.Dittman,Maug,andSpalt(2010)showthatimplausible

parametersarenotrequired;forexample,themanager’sreferencewagecanbeclosetolastyear’s

salaryandbonus.Themanager’srisktoleranceisnearzeroaroundthereferencepointbut

increasesrapidlyaspayoutincreases.Thisnecessitateshigh‐powered,convexcontractsevenwith

optimalrisksharing.Thisisconsistentwithhighsalariesandpositivestockandstockoption

holdingsthatweobserve.

4.   Behavioral Signaling 

Anotherbehavioralapproachtocorporatefinanceisinanembryonicstage.Weincludeit

alongsidemorematureresearchframeworksbecauseofitstheoreticaldistinctivenessandseeming

promise.Wealsohappentofinditinterestingourselves;ourdiscussionherewillfocusonBaker

andWurgler(2011).Themodelinvolvesquasi‐rationalinvestors,soinaconceptualsenseitfalls

betweenthemarkettimingandcateringresearch,whichassumesirrationalinvestors,andthe

managerialbiasesresearch,whichassumesfullyrationalinvestors.

ThecoreideaofsignalingmodelssinceSpence(1973)isthat“good”typescanseparate

themselvesbytakingsomeactionthatislesscostlyforthemthanitisfor“bad”types.Incorporate

finance,classicapplicationsincludethecapitalstructuremodelsofLelandandPyle(1977),Ross

(1977),andMyersandMajluf(1984);thedividendmodelsofBhattacharya(1979),Johnand

Williams(1985),andMillerandRock(1985);theconvertibledebtmodelofHarrisandRaviv

(1985);and,theIPOunderpricingmodelsofAllenandFaulhaber(1989),GrinblattandHwang

(1989),andWelch(1989).Althoughthenatureofthesignalingmechanismvaries,allofthese

modelsfeatureparticipantswithstandardpreferencesandrationalexpectations.

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Thedefiningcharacteristicofbehavioralsignalingmodelsisthatthesignalingmechanism

derivesfromnonstandardpreferencesorjudgmentalbiases.Themodelofdividendpolicywe

discussbelowisanexample.Itreliesonprospecttheorypreferencesandnarrowframing.

4.1.  Theoretical Framework 

Thereisnostandardtheoreticalframeworktooutlinehereatthistime.Indeed,thereare

manybehavioraldistortionsonecouldimaginebasingasignalingmodelupon,andeachmighthave

asomewhatdifferentimplementationandapplication.Wewillreviewaspecificmodelofdividend

signalingbasedonBakerandWurgler(2011).

Themaingoalofthisdividend‐signalingmodelis,asusual,toexplainwhyfirmspay

dividendsatall.Secondarygoalsaretoshedlightonotherfactsofdividendpolicy.Theseinclude

thefactthatdividendsareoftennotraisedorloweredforlongstretches;thatdividendcutsare

greetedverynegatively;and,thatdividendscanbedescribedusingtheLintner(1956)partial‐

adjustmentmodel.Weoutlinethemodelandthenreturntomoredetailedempiricalimplications.

Thesignalingmechanismisbasedonnonstandardinvestorpreferences,notwillful

destructionoffirmvaluethroughinvestmentdistortionsortaxes.Inparticular,itisbasedonthe

referencedependenceandlossaversionfeaturesoftheprospecttheoryvaluefunctionof

KahnemanandTversky(1979).Referencedependencereferstothepropensitytojudgeutility

basedonlossesandgainsrelativetoacontext‐specificreferencepoint.Lossaversiondenotesthe

tendencytoperceivemoredisutilityfromlossesthanutilityfromequal‐sizegains.Sufficeittosay

thatagreatdealofresearchfrompsychologyandeconomicssupportstheseeffects—see,e.g.,

Kahneman(2003).

Themodel’sfirstkeyingredientisthatareferencepointlevelofdividendsappearsinthe

investor’sobjectivefunction.Perlossaversion,thereisakinkinutility,sothatthenegativeeffectof

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a$0.01dropindividendsjustbelowthereferencepointisgreaterthanthepositiveeffectofa$0.01

increaseindividendsjustabove.Thesecondkeyingredientisthatthemanagercaresaboutthe

currentestimateoffirmvalueaswellasthelong‐termwelfareofinvestors.

Themodelfocusesontwoperiods:t=1and2.Therearetwoplayers:abenevolent

managerandaninvestortowhomdividendcutsfromthecurrentreferencepointlevelare

discontinuouslypainful.Inthefirstperiod,theinvestorarriveswithanexogenousreferencepoint

d*.Themanageralsoreceivesprivateinformationaboutcashearnings1andpaysadividendd1in

thefirstperiod.Giventhisdividend,theinvestorlearnssomethingaboutthemanager’sprivate

informationandhencethevalueofthefirm.Thisdividend,whichmaybebelow,above,orequalto

d*,inturnformsanewreferencepointfortheliquidatingdividendd2.Insomeways,thismodelcan

beviewedasasnapshotofamulti‐periodmodel.

Inthismodel,referencepointsshapedividendpolicyinmultipleways.Ontheonehand,to

theextentthattoday’sdividendisthereferencepointagainstwhichfuturedividendpaymentswill

bejudged,themanagerwouldliketorestraincurrentdividends,savingsomeresourcesforthenext

periodtomakeupforapossibleshortfallinfutureearnings.Ontheotherhand,settingasideeffects

onfutureinvestorwelfare,themanagerwouldliketopayadividendtodaythatexceedsthecurrent

referencepoint.Moreover,becausethemanageralsocaresaboutthecurrentestimateoffirmvalue,

whichforsimplicitywetaketomeantheestimateoffirstperiodcashearnings,hemightalso

increasedividendsbeyondthecurrentreferencepointtosignalprivateinformationaboutthe

firm’sabilitytopay.Thissignalingmechanismworksbecausefirmswithlimitedresourcesare

unwillingtoincurtheexpectedfuturecostofmissinganendogenousreferencepoint.Comingback

totheformalities,wehave:

74

Managerutility.Themanagercaresaboutwhattheinvestorthinksabout1todaybecause

thatdeterminestoday’sstockprice.Healsocaresabouttheinvestor’slongrunutility.The

simplifiedobjectivefunctionis:

*211 |,1 ddduEE im ,

whered1andd2aretheperiod‐specificdividendsofthefirm,uistheinvestor’sutilityfunction,

givenanexogenousinitialreferencepointofd*,andEmandEiaretheexpectationsoperatorsforthe

managerandtheinvestor,respectively.35

Investorutility.Themanager’sobjectiveisstandard.Theinterestingaspectofthis

signalingmodelisthattheinvestorhasakinkinhispreferencesfordividendsd1andd2.Thefirst

kinkisaroundanexogenousreferencepointforfirstperioddividendsd*andthesecondkinkis

aroundanendogenousreferencepointforsecondperioddividends:

u d1, d2 | d* d1 b d1 d * d1 d * d2 b d2 d1 d2 d1 .

Inotherwords,theinvestorcaresaboutfundamentalvalue,ortotaldividendpayments,but

withatwist.Thelevelofthereferencepointcomesfromhistoricalfirmdividendpolicy,andbis

greaterthanzerotoincorporatelossaversion.Thisutilityfunctionisinthespiritofprospecttheory

withakinkatareferencepoint.Thesecondperiodreferencepointequalsfirstperioddividendsd1

byassumption.Inreality,thereferencepointandtheintensityofthereferencepointbmaybe

determinedbyalonghistoryoflevelsandchangesindividendpolicy.Thefactthateachdividend

paymentformsaseparatereferencepointalsorequiresnarrowframing.Thisisnotareference

35Thefactthattheinvestor’sexpectationof1appearsdirectlyintothemanager’sobjectiveisaninnocuousassumption,becauseinequilibriumthestockpricewillbealineartransformationofthisexpectation.

75

pointappliedtototalendingwealth,butmuchmorenarrowlybothacrossstocksandtime,inthe

spiritofBarberis,Huang,andThaler(2006).

Information.Forsimplicity,themanagerhasnocontroloverthecashearningsofthefirm.

Thisisabitdifferentfromatraditionalsignalingmodelwherethemanagermustdestroyfirmvalue

toimpressthecapitalmarkets.Thereisalsonoagencyproblem;themanagerisnotabletokeepthe

cashforhimself,andnorealvalueiscreatedordestroyedwithdividendpolicy.Thefundamental

valueofthefirmappearsintwoinstallmentsandtotals 21 .Thinkoftheseascashearningsthat

arenotobservabletotheinvestor.Thisisanextremeassumptionofasymmetricinformationthat

highlightstheintuition.Forsimplicity,assumethatthesecond‐periodcashearningshaveauniform

distribution, 2,0~2 U .

Budgetconstraint.Thereisnonewequityordebtavailabletofinancethepaymentof

dividendsandnoexcesscashbalancesavailableinthefirstperiod.Themostthemanagercanpay

inthefirstperiodis1,andthemosthecanpayinthesecondperiodis2plusanysavingsfromthe

firstperiod.Givenabenevolentmanagerandtheabsenceofnewfinancing,thisimpliesconstraints:

110 d and 1212 dd .

Equilibrium.Combiningtheabove,therearethreeimportanteffectsthatappearinthe

manager’sobjectivefunction.First,thereissometimesanadvantagetopayingoutdividends

immediately.Considerafirstperioddividendbelowthereferencepointd*.Settingasidetheeffect

onthesecondperiodreferencepoint,thesedividendswillbevaluedonthemarginatb+1timesthe

payout,insteadofsimplythepayout.Aboved*,thereisnomarginalbenefitfrommerelyshifting

payoutfromthesecondperiodforward.Second,byincreasingthedividendtoday,theinvestor’s

estimateEi[1]oftheunobservablecashearningsrisesthroughanequilibriumsetofbeliefsthat

mapdividendpolicytocashearnings.Thisentersintothemanager’sutilityfunctiondirectly.Third,

76

increasingthedividendinthefirstperiod,foreitheroftheserationales,producesanexpected

futurecosttoinvestorutilitythatcomesfromthepossibilityoffallingshortofthereferencepoint

setforthesecondperiod.

Thesethreemotivationscombinetosimplifythemanager’sutilityfunction:

1 b d1 d * d1 d * Ei 1 | d1 1 b d1 1

2

2

d1 1

2

Thefirsttermreflectsstrivingtoavoidfallingshortoftheinitialreferencepoint.Thesecondterm

reflectsconcernaboutshareprice.Thethirdtermreflectstheexpectedcostoffallingshortofanew

referencepoint;thereisnocostifthemanageradoptsaveryconservativedividendpolicyofpaying

halfoffirst‐periodearnings.Giventheuniformdistributionof2,theexpectedcostisquadraticas

dividendsrisefromthispointandincreasingintheintensityofthereferencepoint.

Intuitively,theseconsiderationssuggestthreerangesofdividendpoliciesinequilibrium.

Thereisahighpayoutratioforfirmswiththeextramotivationduetosignalingtocleartheinitial

referencepointofd*.Next,managersclusteratd*oncethismarginaleffectdropsout,i.e.they

maintaintheirexistingdividendlevelexactly.Finally,thereisalowerpayoutratioforfirmswith

first‐periodearningswellabovetheinitialreferencepoint.Theseluckyfirmsnonethelesspay

higherdividendstoseparatethemselvesfromeachotherandfromthepoolatd*.Specifically,there

existsanequilibriumwhere:

d1=1if1<d*,

=d*ifd*<1<*,and

= 12 1

1 1b if1>*,

77

with*satisfying 12 *d * 1 b

1 1b 2 d * 1

2 * 2 0 ,

and equilibrium beliefs of:

Ei[1 | d1]= d1 if d1 < d*,

= **21 d if d1 = d*,and

= 2 d1 1 1

b if d1 > 12 *

1 1b .

Thereareintuitivecomparativestaticswithrespecttob,thecostoffallingbelowthe

referencepoint.Inthisequilibrium,itcanbeshownthatasbincreasesanddecreases,thereis

moreclusteringofdividendsatthereferencepointd*(*increases),andthemarketreactiontod1<

d*increases,becausethereismoreinformationrevealedinanearmiss.

4.2.   Applications 

Wewilldiscusstheempiricalrelevanceofthisdividend‐signalingmodelandthenspeculate

abitaboutpotentialfutureapplicationsofbehavioralsignaling.

4.2.1  Dividends 

Animportantfeatureofthereferencepointsmodelisthatitisconsistentwithwhat

managerssayaboutdividendpolicy.IntheBravetal.(2004)survey,executivesdisavowthenotion

thattheypaydividendsbecauseitdestroysfirmvalueandthereforesignalsstrength.Thisisthe

basis,however,ofnumerousnon‐behavioralsignalingmodels.Atthesametime,managersdoagree

withthenotionthatdividendsarea“signal”ofsomesort.Thebehavioralsignalingmodelwith

dividendsasreferencepointscansignalfinancialsoundnesswithoutburningmoney.

78

BehavioralsignalingcanalsogivefoundationstotheLintner(1956)model,whichhas

provedadifficulttaskusingtraditionalapproaches.Intheequilibriumdescribedabove,firmswith

goodearningsrealizations(1>*)followapartial‐adjustmentpolicyandaremoregenerally

smoothedrelativetoearnings.TheLintnermodeltakesthepreviousdividendasthestartingpoint

foranyadjustmentinthisperiod;thebehavioralsignalingmodelpredictsthatthedividendlevel

willbeconstantformanyfirmsandadjustedonlywhenearningsaresufficientlyextreme.On

averageforallfirms,dividendsincreaselessthanone‐for‐onewithearnings,consistentwithpartial

adjustment.

Thereactiontodividendchangesisasymmetric,withcutsbeingparticularlypainful

(AharonyandSwary(1980)).Moststandardsignalingmodelsdonotincorporatethisasymmetry.

Ontheotherhand,itimmediatelyfollowsfromamodelwithloss‐averseinvestorswhouselagged

dividendsasareferencepoint—therelevanteffectisthatcuttingdividends,evenslightly,fully

revealsthatthefirm’sfinancialstrengthislow.

Afundamentalthemeofthemodelisthatthelevelofdividendsneedstobesalientand

memorableinordertomaximizethestrengthofthesignal.Ifinvestorsdon’tnoticetheirdividend

ordon’tnoticechanges,thereference‐pointmechanismfails.Infact,similartowhatThomas(1989)

findsinearningslevels,dividendlevelsandchangestendalsotobeineasy‐to‐digestround

numbers,suchasmultiplesoffiveandtencentspershare.Thisfeatureofdividendpolicyagainhas

nonaturalinterpretationwithintraditionalsignalingtheories.

4.2.2.   Other applications 

Earningsmanagementpresentsanotherpotentialapplicationforbehavioralsignaling.

Importantfeaturesofthereportedearningsprocessarereminiscentofthedividendprocess.

BurgstahlerandDichev(1997)andDegeorgeetal.(1999)findthatearningsaremanagedtomeet

orexceedsalientreferencepoints.Asdiscussedearlier,theseincludezeroearnings,lagged

79

earnings,andanalystexpectations.Inaddition,reportedearningsaresmoothedversionsoftrue

earnings,involvingapartial‐adjustmentprocessnotunliketheLintnermodel.

Aloss‐aversionbasedmechanismisn’tasnaturalintheearningscontext,however.

Reportedearningsarelesstangibleandvisibletothemassofinvestorsthandividends;loss

aversiontoreportedearningsperseisunnatural.36Amorerealisticsignalingmechanismmightbe

basedonirrationalbeliefs.

Forexample,supposethatinvestorsoverreactifreportedearningsfallbelowthethreshold

ofpriorearnings.(SkinnerandSloan(2002)findthatgrowthfirms,forwhichinformationopacity

ishighestandsignalingmostuseful,doexhibitanasymmetricresponsetoearningssurprises.)

Reportedearningscanthenbecomeasignal:Managerswithfavorableprivateinformationcan

aggressivelymanipulateearningsupwardandestablishhigherreferencepointsforfutureearnings.

Distinguishingbetweentwotypesofinvestors—noisetraderswithincorrectbeliefsand

arbitrageurswithrationalexpectationsbutlimitedcapitalandrisk‐bearingability—allowsoneto

preservearationalexpectationsequilibriumconcept.Inthissetup,managersareessentially

signalingtothearbitrageurs;thenoisetradersprovidethemechanism.

Stocksplitshavealsobeenmodeledassignalsinrationalexpectationsframeworks,without

clearsuccess.ThecostlysignalingmechanismsinBrennanandCopeland(1988)andBrennanand

Hughes(1991)involvetransactioncosts:roughlyspeaking,firmssplittolower‐pricedsharesto

increasetradingcostsontheirinvestors.Unfortunately,BakerandPowell(1993)surveymanagers

andtheysaythatsplitsareifanythinganefforttoimproveliquidity.

36Ontheotherhand,Degeorgeetal.proposethatexecutivesthemselvesmayderivepersonalutilityfrommeetingthresholds.

80

Itisnothardtosketchasimplebehavioralsignalingmodelofsplitsthatismoreintuitive.

Forexample,supposethatnoisetraderscoarselycategorizelow‐nominal‐pricefirms,allelseequal,

asgrowthfirms(Baker,Greenwood,andWurgler(2009)).Inthisenvironment,splitterscan

crediblyseparatethemselvesintheeyesofrationalarbitrageursbecausetheyknowtheycan

deliverhigherearningsnextperiodandnotriskthewrathofthenoisetraders.SkinnerandSloan’s

(2002)resultsarealsocompatiblewiththissimplemodel.

5.   Conclusion 

Thebehavioralcorporatefinanceliteraturehasmaturedtothepointwhereonecannow

sketchoutahandfulofcanonicaltheoreticalframeworksandusethemtoorganizemanydozensof

empiricalstudies.Ourreviewofthisevidenceindicatesthatbehavioralapproachesofferauseful

complementtotheothercorporatefinanceparadigms.Theydeliverintuitiveandsometimesquite

compellingexplanationsforimportantfinancingandinvestingpatterns,includingsomethatare

difficulttoreconcilewithexistingtheory.

Initscurrentstateofflux,thefieldoffersanumberofexcitingandimportantresearch

questions.Weclosebyhighlightingjustafew.Innoparticularorder,wewonder:

Arebehavioralfactorsattherootofwhymanagersdonotmoreaggressivelypursuethetax

benefitsofdebt,asinGraham(2000)?Hackbarth(2009)developsatheoreticalargument

alongtheselines.

Whiletheexistingliteraturehasgenerallyconsideredthetwoapproachesseparately,the

irrationalmanagerandirrationalinvestorstoriescancertainlycoexist.Wouldamodel

featuringacorrelationbetweeninvestorandmanagerialsentimentleadtonewinsights?

81

Whatotherphenomenacanbemodeledwithbehavioralsignaling?Howcansuchmodelsbe

tested?

Whatarethedeterminantsofmanagerial“horizons,”andhowcantheybemeasuredand

appropriatelygoverned?

Towhatextentshouldinvestmentbankersbeviewedasinstitutionswhosebusinessmodel

istoidentifyandcatertoemergingpocketsofinvestorsentiment?

Towhatextentshouldprivateequityfundsbeviewedasfirmswhosebusinessmodelisto

capitalizeonequityanddebtmarketsthatarenotfullyintegrated,withseparateinvestor

demandshocksandinconsistentpricing?

Whatarethebehavioralexplanationsfortherecentfinancialcrisis?Barberis(2011)starts

toconnectthedots.

Howisthebankingsystemaffectedbyinefficienciesinthecapitalmarkets?Should

regulationaimtoinsulatebanksfrombubbles?Shouldthisoperatethroughbroadcapital

regulations,ormorenarrowly?

Arederivativeinstruments–mostnoteworthyinrecenthistory,creditdefaultswaps(CDS)

andCDOs–pronetomisvaluation?Towhatextentdotheymakecorporateoutcomesmore

efficientbyloweringtheexantecostofcapitalthroughefficientrisksharingorby

predictingdefault?Towhatextentaretheythesourceofmispricingsthatpropagateinto

debtandequityprices?

Whatdeterminesinvestorsentiment,andhowisitmanagedthroughcorporateinvestor

relations(BrennanandTamarowski(2000))?Potentialavenuestoconsiderareinteractions

82

withpaststockmarketreturns,technologicalchangeandthevaluationofnewindustries,

mediacoverage,financialanalystsandfinancialreporting,andinvestmentbanking.

Doequityanddebtmarkettimingreducetheoverallcostofcapitalbyasmallamountora

largeamount?Dichev(2004)offersanapproachhere.

Towhatextentcanfeaturesoffinancialcontractsandsecuritiesbeunderstoodasa

responsetoassortedbehavioralbiases?Williamsontookfirststepshere.Inthecontextof

consumercontracts,DellaVignaandMalmendier(2004)suggestthatcreditcardsand

healthclubcontractsareshapedbynaïveexpectationsandtime‐inconsistentpreferences.

Whatistheimpactofinvestorinertiaandlimitedattentiononcorporatefinance?Baker,

CovalandStein(2007)andDellaVignaandPollet(2009)considerstockswapsandthe

timingofcorporatedisclosure.HirshleiferandWelch(2002)developimplicationsfor

organizations.

Howshouldoneapproachtheproperregulationofinefficientmarketsandfinancial

reporting?ThefinancialcrisishasgenerateddiscussionabouttheroleoftheFedandthe

SECwithregardtoidentifyingandmanaginginvestorsentimentandbubbles.

Whatarethelimitsofcorporatearbitrage,includingdetectingandgeneratingmispricing,

maintainingreputation,andavoidingfraud?

Canacateringapproachhelptoexplainthediversificationandsubsequentre‐focuswave

thathastakenplaceintheUSsincethelate‐1960s?

Howsignificantistheeconomy‐widemisallocationofcapitalcausedbycollectedbehavioral

distortions,andinparticularhowdothesedistortionsinteractwithtraditionalcapital

marketimperfections?Forexample,ifthereisunderinvestmentduetoagencyor

83

asymmetricinformation,bubblesmaybringinvestmentclosertotheefficientlevel—or

overshoot.

Ifboundedrationalityorinvestorpressuresleadmanagerstorelyonspecificperformance

metrics,willthirdpartiesexploitthis?Themarketingoftakeoversandfinancingvehiclesas

EPS‐improvingtransactionsbyinvestmentbanksisapotentialexample.Moregenerally,

whatprofitopportunitiesarecreatedbybehavioralbiasesofinvestorsandmanagers?

Towhatextentarecorporate“hedging”policiesactuallydirectionalbets?Theevidencein

Brown,Crabb,andHaushalter(2002)andFaulkender(2005)suggeststhatinmany

companies,interestrateriskmanagementandtheuseofderivativeshaslittletodowith

textbookhedging.

Whatarethenormative,legal,andethicalimplicationsofmarket‐drivencorporatefinance?

Shouldmanagersbeencouragedtorespondtomovementsinpricesandinterestratesthat

donotreflectunderlyingfundamentals?Jensen(2005)explorestheagencyproblemsthat

arisefromovervaluedequity.

IntheIntroduction,wepointedoutthatthenormativeimplicationofassumingirrational

investorsistoinsulatemanagersfromshort‐termmarketpressures,whiletheimplication

ofassumingirrationalmanagersapproachistoobligatethemtofollowmarketprices.What,

intherealworld,istherightbalancebetweendiscretionandmarketpressure?

84

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