Study of how owners and managers of publicly-traded companies make decisions that affect the values of those companies. Examines effects of manager’s and investor’s psychological biases on firms corporate finance decisions. Main psychological traps met are: confirmation bias, hindsight bias, herding behavior conservatism, the role of affects, wishful thinking, opaque framing, representativeness bias and overconfidence. “Real-world” view- Managers and investors may be irrational (Psychological Biases) (“homo sapiens” view). Behavioural Corporate Finance: considers managerial irrationality/biases. Focus on corporate finance decisions (investment appraisal, capital structure/dividend policy. How the personal traits of managers affect the decisions made in the firm, especially financial decisions. We will see that the psychological qualities of individuals holding management positions have a decisive effect on. For instance, their financing and capital budgeting decisions or their dividend policy. It will also become clear that the psychological profile of each manager will provide an explanation for the financial decisions made beyond the scope of the company and its business sector. Assumptions of Behavioural Corporate Finance Assumes irrational entrepreneurs or managers Postulates irrational investors and limited arbitrage. The Rational Managers with Irrational Investors Approach This approach assumes that securities market arbitrage is imperfect, and thus that prices can be too high or too low. Rational managers are assumed to perceive mispricings, and to make decisions that may encourage respond to mispricing. Rational manager objectives in irrational market: 1. Fundamental value - Maximizing fundamental value has the usual ingredients. 2. Catering - Catering refers to decisions that aim at boosting stock price above the level of intrinsic value. 3. Market timing - Market timing relates to the decision that aims at exploiting temporary mispricing. Two Key Building Blocks: 1. Limits on arbitrage - Irrational investors impact prices because arbitrage is limited. 2. Smart managers - Managers have the ability to detect when valuations are wrong and they act on mispricing.

1. Behavioural Finance
Unit-IV
Behavioural Corporate Finance
Rational Managers with Irrational Investors Approach;
Behavioural Factors based on Capital Structure, Capital
Budgeting, Dividend Policy, Mergers and Acquisitions,
Agency Conflicts and Corporate Governance; Challenges
Agency Conflicts and Corporate Governance; Challenges
in Building a Psychologically Smart Organisation.
Prepared by
Mr. Dayananda Huded M.Com NET, KSET
Department of Studies in Commerce
Rani Channamma University, PG Centre, Jamkhandi-01
E-mail: dayanandch65@gmail.com
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Mr. Dayananda Huded

2. Behavioural Corporate Finance
• Study of how owners and managers of publicly-traded companies make decisions that
affect the values of those companies.
• Examines effects of manager’s and investor’s psychological biases on firms corporate
finance decisions.
• Main psychological traps met are: confirmation bias, hindsight bias, herding behavior
conservatism, the role of affects, wishful thinking, opaque framing, representativeness
bias and overconfidence.
• “Real-world” view- Managers and investors may be irrational (Psychological Biases)
(“homo sapiens” view).
(“homo sapiens” view).
• Behavioural Corporate Finance: considers managerial irrationality/biases. Focus on
corporate finance decisions (investment appraisal, capital structure/dividend policy.
• How the personal traits of managers affect the decisions made in the firm, especially
financial decisions. We will see that the psychological qualities of individuals holding
management positions have a decisive effect on.
• For instance, their financing and capital budgeting decisions or their dividend policy.
It will also become clear that the psychological profile of each manager will provide
an explanation for the financial decisions made beyond the scope of the company and
its business sector.
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Mr. Dayananda Huded

3. • Assumptions of Behavioural Corporate Finance
– Assumes irrational entrepreneurs or managers
– Postulates irrational investors and limited arbitrage.
• Corporate Dividend Policy
• Refers to the practice that management follows in making dividend
payout decisions.
• Have impact on financing decisions of the firm.
• Have impact on financing decisions of the firm.
• Dividends are payments made by a corporation to its shareholders.
• Concerned with taking decision regarding paying cash dividend in the
present or paying an increased dividend at a later stage
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4. Empirical Data on Dividend Presence
• M&M termed tendency of investors to be attracted to a certain type of dividend-
paying stocks a “dividend clientele effect”
• In a perfect market, each clientele is “as good as another”, thus dividend policy
remains irrelevant
• Dividends per share refers to the amount shareholders earn for each share,
calculated by dividing total dividend amount by total number of shares
outstanding
• Linter model is a basic model that incorporates the dominant determinants of
corporate dividend decisions
corporate dividend decisions
• If investors migrate to firms that pay the dividends that most closely match their
needs, no firm’s value should be affected by dividend policy
• If a firm rigidly follows the residual distribution policy, then distributions paid in
any given year can be expressed as follows
• Distributions = Net Income – Retained earnings needed to finance new
investments
• OR
• Distributions = Net Income – [(Target equity ratio) x (Total capital budget)]
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5. Timing of Good and Bad Corporate News Announcement
• Time for releasing all relevant information pertaining to a company that
may influence an investment decision
• An accurate timing of good and bad news announcement leads to
effective decision-making
• Principle of manager:
• 1. Assume that loose lips sink corporate ships
• 2. Consider honesty to be the best policy
• 3. Listen to individual’s stock prices
• 3. Listen to individual’s stock prices
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6. Rational Managers with Irrational Investors Approach
• The Rational Managers with Irrational Investors Approach
• This approach assumes that securities market arbitrage is imperfect, and thus that
prices can be too high or too low. Rational managers are assumed to perceive
mispricings, and to make decisions that may encourage respond to mispricing.
• Rational manager objectives in irrational market:
• 1. Fundamental value - Maximizing fundamental value has the usual ingredients.
• 2. Catering - Catering refers to decisions that aim at boosting stock price above
the level of intrinsic value.
• 3. Market timing - Market timing relates to the decision that aims at exploiting
• 3. Market timing - Market timing relates to the decision that aims at exploiting
temporary mispricing.
• Two Key Building Blocks:
• 1. Limits on arbitrage - Irrational investors impact prices because arbitrage is
limited.
• 2. Smart managers - Managers have the ability to detect when valuations are
wrong and they act on mispricing
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7. Behavioural Factors based on Capital Structure
• Capital structure is one of the most controversial issues in corporate
finance.
• There are several different approaches that constitute the theory of capital
structure; however none of them seems to prevail in practice so far. The
plethora of contradictive empirical evidence continuously raises questions
about the validity of each approach leading researchers to focus deeper in
the real factors that determine capital structure in practice.
• Examines the relationship between anchoring as a behavioural bias
• Examines the relationship between anchoring as a behavioural bias
exhibited by managers and their decisions on whether to issue debt or
equity.
• The argument put forward is derived from the market timing argument, in
which managers decide on whether to issue debt or equity based on their
perception of whether the value of the firm, given by its share price and
market capitalization, is overvalued or has peaked or is undervalued.
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8. • Investigate whether anchoring captured by a number of proxies including
marketto-book ratios, the proportion of shares sold off that are held by managers,
the exercising of stock options held by managers long before their expiration
dates, share repurchases, stock returns, bond yields, 52-week share price highs,
and share prices at last equity issue and last debt issue, sufficiently explains the
changing levels of debt or capital structure mix adopted by firms.
• Modigliani and Miller (1958) put forward the argument that a firm’s capital
structure does not affect the value of the firm, implying that debt policy is
irrelevant. They revised their view a few years later taking into account a tax
irrelevant. They revised their view a few years later taking into account a tax
environment and argued that because of interest tax shields, debt increases the
value of the firm, but up to a point. This point is regarded as the point at which
the cost of financial distress more than outweighs the benefits from interest tax
shields, and this gives us the Trade-off Theory (Modigliani and Miller, 1963).
• The first option is to use cash from retained earnings, and if this is not available
or becomes exhausted they will issue debt, and if they are unable to or find the
cost too high, they will issue equity as a last resort. This argument gives us the
Pecking Order Theory of Capital Structure.
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9. Behavioural Factors based on Capital Budgeting
• Overconfidence Bias will be influential here.
• Capital budgeting is the process by which firms determine how to invest
their capital. Included in this process are the decisions to invest in new
projects, reassess the amount of capital already invested in existing
projects, allocate and ration capital across divisions, and acquire other
firms. In essence, the capital budgeting process defines the set and size of
a firm’s real assets, which in turn generate the cash flows that ultimately
determine its profitability, value, and viability.
• In principle, a firm’s decision to invest in a new project should be made
according to whether the project increases the wealth of the firm’s
shareholders. For example, the net present value (NPV) rule specifies an
objective process by which firms can assess the value that new capital
investments are expected to create.
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10. • First, capital budgeting decisions can be complex. They often require projecting
cash flows for a wide range of uncertain outcomes. People are typically most
overconfident about such difficult problems.
• Capital budgeting decisions are not well suited for learning. As Kahneman and
Lovallo (1993, p. 18) note, learning occurs “when closely similar problems are
frequently encountered, especially if the outcomes of decisions are quickly
known and provide unequivocal feedback.” In most firms, managers infrequently
encounter major investment policy decisions, experience long delays before
learning the outcomes of projects, and usually receive noisy feedback.
learning the outcomes of projects, and usually receive noisy feedback.
Furthermore, managers often have difficulty rejecting the notion that every
situation is new in important ways, allowing them to ignore feedback from past
decisions altogether.
• Unsuccessful managers are less likely to retain their jobs and be promoted. Those
who succeed may become overconfident because of a self-attribution bias. Most
people overestimate the degree to which they are responsible for their own
success (Miller and Ross, 1975; Langer and Roth, 1975; Nisbett and Ross, 1980).
This self-attribution bias causes successful managers to become overconfident.
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11. • Managers may be more overconfident than the general population
because of a selection bias. Those who are overconfident and optimistic
about their prospects as managers are more likely to apply for these jobs.
Moreover, as Goel and Takor (2008) show, firms may endogenously
select and promote on the basis of overconfidence, as overconfident
individuals are more likely to have generated extremely good outcomes in
the past.
Overconfidence v/s Optimism
• The meaning of overconfidence is different from that of optimism, the
belief that favorable future events are more likely than they really are.
Researchers generally find that individuals are unrealistically optimistic
about future events. They expect good things to happen to them more
often than to their peers (Weinstein, 1980; Kunda, 1987). For example, Ito
(1990) reports that foreign exchange companies are more optimistic about
how exchange rate moves will affect their firm than how they will affect
others.
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12. Behavioural Factors based on Dividend Policy
• Factors:
• 1. First of all, it is easy to understand that the tax system may influence corporate
dividend policy.
• 2. Mental Accounting Bias, loss aversion, ambiguity and level of time
discounting are the main determinants of corporate dividend policy.
• 3. Signalling aspects (signaling theory): Signaling theory is the belief that
information on a company's financial health is not available to all parties in
a market at the same time.
• Signaling refers to the act of using insider information to initiate a trading
• Signaling refers to the act of using insider information to initiate a trading
position. It occurs when an insider releases crucial information about a company
that triggers the buying or selling of its stock by people who do not ordinarily
possess insider information.
• Signaling theory states that corporate financial decisions are signals sent by the
company's managers to Investors in order to shake up these asymmetries. These
signals are the cornerstone of financial communications policy.
• 4. Dividend payments also increase the risk of default by reducing the amount of
assets that is accessible for debt holders.
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13. • 5. Dividends are “a bird in the hand”, while retained gains only lead to
uncertain future earnings so that investors prefer dividends even if
retained gains and future earnings are completely reflected in current
stock prices. People thus tend to perceive dividends as a safety net which
is solely a psychological phenomenon, because selling a stock yields the
same monetary effect as dividend payments.
• 6. Mental accounts may not always be segregated.
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14. Behavioural Factors based on Mergers & Acquisition
• Mergers and acquisitions (M&A) are among the key strategic decisions
that firms make. But the problem is that they often result in failure and
impairment loss, with the fair value of the acquisition price becoming an
issue that poses the risk of overvaluation.
• The behavioral perspective regarding M&A is first proposed by Roll
(1986), who hypothesizes that overconfidence (or hubris) explains the
observed negative stock performance of acquirers.
• Biases causing overvaluation include overconfidence by managers; an
• Biases causing overvaluation include overconfidence by managers; an
escalation of bidding prices leading to winner’s curse; anchoring in
pricing; the endowment effect; and hindsight and confirmation biases.
• Corporate governance architecture can be designed to mitigate these
biases while preserving the positive aspects of overconfidence, such as its
promoting of productive and creative activities and coherent internal
management
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15. Reasons for Merger Failures
• Limited Owner Involvement
• Mis-valuation
• Poor Integration Process
• Cultural Integration Issues
• Large Required Capacity
• High Recovery Costs
• Negotiation Errors
• External Factors
• Assessment of Alternatives
• Backup Plan
• The Bottom Line: Business owners, advisors, and associated participants
should be vigilant (careful or cautious) about the possible pitfalls.
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16. Agency Conflicts (Behavioural Factors)
• Meaning: A principal-agent conflicts arises when there is a conflict of interest
between the agent and the principal, which typically occurs when the agent acts
solely in his/her own interests. In a principal-agent relationship, the principal is
the party that legally appoints the agent to make decisions and take actions on its
behalf.
• Agents are commonly engaged by principals due to different skill levels, different
employment positions, or restrictions on time and access. The agency problem
arises due to an issue with incentives and the presence of discretion in task
completion. An agent may be motivated to act in a manner that is not favorable
completion. An agent may be motivated to act in a manner that is not favorable
for the principal if the agent is presented with an incentive to act in this way.
• There can be various causes of agency problems. These causes differ from the
position of an individual in the company. However, the root cause of these
problems is the same in all mismatch or conflict of interests cases.
• When the agenda of the stockholder clashes with the other groups, the agency
problem will occur.
• In the case of employees, the reason would be the failure of stockholders to meet
employees’ expectations concerning salary, incentives, working hours, etc.
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17. • In the case of customers, the cause would be the failure of stockholders to meet
customers’ expectations like the sale of poor-quality goods, poor supply, high
pricing, etc.
• In the case of management, the causes of agency problems could be the
misalignment of goals, separation of ownership and control, etc.
• The main reasons for the principal-agent problem are conflicts of interests
between two parties and the asymmetric information between them (agents tend
to possess more information than principals).
• The principal-agent problem generally results in agency costs that the principal
• The principal-agent problem generally results in agency costs that the principal
should bear. Because agents can act in their interests at the principals’ expense,
the principal-agent problem is an example of a moral hazard.
• Managers and shareholders have different aims. The objective of shareholders is
to maximise their wealth, which are high dividends and high share price.
However, managers do not always perform to maximise shareholders’ wealth
since they will enjoy very little of that wealth. Rather, they want to maximize
their salary/income, fringe benefits and job security
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18. • Managers favour lower risk projects and lower debts as high risk and debts
increase the risk of bankruptcy and losses (Jerzemowska, M., 2006). On the other
hand shareholders prefer risky projects that involve high cash-inflows and high
returns and they encourage managers to finance the project by borrowing
additional debts.
• Sources of conflicts between shareholders and creditors
• 1. High dividend pay-out is a major source of conflict between them
• Shareholders always try to maximize their wealth by asking for high dividend.
While the dividend of shareholders increases, interest paid to creditors remains
the same. Subsequently, high dividend increases the market value of shares but
the same. Subsequently, high dividend increases the market value of shares but
decreases the market value of bonds. Hence, shareholder wealth maximization
causes a decrease in creditors’ wealth.
• 2. Conflicts arise through the choice of projects
• Shareholders try to cause the company to implement risky projects with high
returns prospects. However, creditors prefer low risks project/investment
whereby the probability of success and loan repayment are higher. If the risky
project is successful, shareholders will benefit from higher dividends as the
business performance improves while creditors do not get to share that they only
receive fixed interest.
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19. • Types
• There are two main types of agency relationships that exist in a
firm, namely,
• Between shareholders and mangers
• Between shareholders and creditors
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20. Corporate Governance
• Corporate governance is concerned about the ways in which investors assure
themselves of getting a return on their investment, on one hand, and is focus on
motivating managers to increase the company profit, on the other hand.
• Corporate governance emerges from the interaction between managers and
investors.
• Managers are often more likely to invest the extra cash-flow or profit than to
return it to shareholders. But, both managers and investors are lees then fully
rational.
• Sometimes their behavior is based on cognitive psychology.
• Sometimes their behavior is based on cognitive psychology.
• In this context, we are dealing with two problems: managerial biases and
irrational investors.
• Managerial biases focus on the illusion of optimism and overconfidence.
• Irrational investors can produce overreaction to something and under-reaction to
other thing.
• We try to emphasize that both managerial biases and irrational investors will
affect corporate governance and furthermore will drive to company distress (even
bankruptcy) if decisions are more based on cognitive psychology than on rational
information. 20
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21. • Corporate governance and corporate finance are about managers,
investors and shareholders.
• Sometimes, they act in an irrational way based on their own perception or
on their own biases.
• Managers may be too optimistic when assessing the profitability of their
investment, investors may have an irrational behavior that can produce a
mispricing and shareholders are too optimistic about the value of their
share and are confronting with disposition effect.
share and are confronting with disposition effect.
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22. • More than that, managers have to find different ways to maximize the
wealth of the shareholders because this represents the goals of businesses,
on one hand, and shareholders have to find ways to motivate managers to
rich their goals, on the other hand.
• In order to manage this kind of conflict, in nowadays, corporate
governance is based on behavioral finance that according to Pompian
(2011) “examines behavior or biases of individual investors that
(2011) “examines behavior or biases of individual investors that
distinguish them from the rational actors envisioned in classical economic
theory”.
• Corporate governance emerges from the interaction between managers
and investors.
• This implies an agency theory perspective in order to balance and manage
the conflict of interest between the two parties.
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23. Managerial Biases and Irrational Investors
• First, managerial optimism predicts the existence of biased cash flow
forecasts.
• Second, managerial optimism predicts pecking order capital structure
preferences.
• Third, managerial optimism predicts efforts to hedge corporate cash flow,
even in the absence of significant asymmetric information, by generating
a false, but perceived wedge between the internal and external cost of
funds.
funds.
• Fourth, managerial optimism predicts takeover resistance”.
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24. Challenges in Building a Psychological Smart Organisation
1) Agency conflicts and lack of collaboration.
2) Behavioural biases
3) Individual differences
4) Difference of opinion
5) Irrational decision based on poor performance
6) Maintaining hide and secrecy among managers or agents
7) Lack of incentives to the managers
8) Lack of dividends to the shareholders
8) Lack of dividends to the shareholders
9) Resistance to change
10) Lack of tolerance in accepting feedback from customers
11) Lack of diversity
12) Wide span of control
13) Restrictions and tough rules
14) Absence of successful innovations
15) Lack of employee engagement and team innovation.
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25. Strategies for Building a Psychological Smart Organisation
• 1. Focus on performance: First, emphasize what most executives want:
performance. Building a psychologically smart environment starts with
shifting the narrative of the intervention from culture change or interpersonal
skills in order to make the case that the quality and candor of conversation
matters for results.
• 2. Train both individuals and teams: Per’s experience as a basketball
player and coach revealed that winning teams undergo two kinds of training:
individual skills (drilling, shooting) and team practice (complex games that
involve real-time coordination using these skills, along with decisions about
involve real-time coordination using these skills, along with decisions about
when to pass, shoot, or dribble). The same is true for management teams.
Individual executives must learn and practice the skills of perspective taking
and inquiry that facilitate candid sharing of ideas and concerns.
• 3. Incorporate visualization: Visualization is used in various settings
ranging from athletes seeking to break a world record to therapists helping
individuals alter troubling behaviors.
• 4. Demonstrate concern for team members as people
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26. • 5. Provide multiple ways for employees to share their thoughts (Employee
participation)
• 6. Show value and appreciation for ideas
• 7. Explain reasons for change
• 8. Increases the amount team members learn from mistakes
• 9. Boosts employee engagement & Improves team innovation
• 10. Build diversity
• 11. Foster Mutual Understanding of Roles and Responsibilities
• 11. Foster Mutual Understanding of Roles and Responsibilities
• 12. Create an Environment Where Team Members Feel They Can Speak Up and
Be Heard—Without Personal Judgment or Attacks
• 13. Everyone deserves to feel like they belong at work; the new-and-
improved Inclusive Behaviors Inventory is an easy-to-use assessment that
allows you to develop your own inclusion profile and get simple steps for
improvement.
• 14. Provide Your Team With Tools That Promote Ongoing Learning, Discussion,
and Engagement
• 15. Democratize functions
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