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Behavioral Corporate Finance: a Current Survey

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Behavioral Corporate Finance: a Current Survey Behavioral Corporate Finance: A Current Survey Forthcoming in Handbook of the Economics of Finance: Volume 2 George M. Constantinides, Milton Harris, and Rene M. Stulz, Eds. Elsevier Press, 2012 Malcolm Baker Harvard Business School and NBER Baker Hall 261 Boston, MA 02163 617‐495‐6566 [email protected] Jeffrey Wurgler NYU Stern School of Business and NBER 44 West 4th St, Suite 9‐190 New York, NY 10012 212‐998‐0367 [email protected] Abstract: We survey the theory and evidence of behavioral corporate finance, which generally takes one of two approaches. The market timing and catering approach views managerial financing and investment decisions as rational managerial responses to securities mispricing. The managerial biases approach studies the direct effects of managers’ biases and nonstandard preferences on their decisions. We review relevant psychology, economic theory and predictions, empirical challenges, empirical evidence, new directions such as behavioral signaling, and open questions. Keywords: Behavioral, Corporate Finance, Sentiment, Catering, Market Timing, Irrational, Bias, Overconfidence, Optimism, Signaling JEL Codes: G14, G30, G31, G32, G34, G35 This survey updates and extends a survey coauthored with Rick Ruback that was published in the Handbook in Corporate Finance: Empirical Corporate Finance, edited by Espen Eckbo, in 2007. We thank him for his many contributions that carried over to this version, and we thank Milt Harris for extensive and helpful comments. Baker gratefully acknowledges financial support from the Division of Research of the Harvard Business School. Table of Contents 1. Introduction ................................................................................................................................... 1 2. Market timing and catering ...................................................................................................... 5 2.1. Background on investor behavior and market inefficiency ................................................. 5 2.1.1. Limited arbitrage ............................................................................................................................................ 6 2.1.2. Categorization and investor sentiment ................................................................................................. 8 2.1.3. Prospect theory, reference points, loss aversion, and anchoring ............................................... 9 2.1.4. Smart managers ............................................................................................................................................ 11 2.2. Theoretical framework: Rational managers in irrational markets ................................. 12 2.3. Empirical challenges ......................................................................................................................... 18 2.4. Investment policy ............................................................................................................................... 22 2.4.1. Real investment ............................................................................................................................................. 22 2.4.2. Mergers and acquisitions .......................................................................................................................... 25 2.4.3. Diversification and focus ........................................................................................................................... 27 2.5. Financial policy .................................................................................................................................. 28 2.5.1. Equity issues ................................................................................................................................................... 28 2.5.2. Repurchases .................................................................................................................................................... 33 2.5.3. Debt issues ....................................................................................................................................................... 34 2.5.4. Cross‐border issues ..................................................................................................................................... 37 2.5.5. Financial intermediation ........................................................................................................................... 37 2.5.6. Capital structure ........................................................................................................................................... 41 2.6. Other corporate decisions ............................................................................................................. 43 2.6.1. Dividends ......................................................................................................................................................... 43 2.6.2. Earnings management ................................................................................................................................ 45 2.6.3. Firm names...................................................................................................................................................... 47 2.6.4. Nominal share prices .................................................................................................................................. 48 2.6.5. Executive compensation ............................................................................................................................ 49 3. Managerial Biases ...................................................................................................................... 50 3.1. Background on managerial behavior ......................................................................................... 50 3.1.1. Limited governance ..................................................................................................................................... 50 3.1.2. Bounded rationality ..................................................................................................................................... 51 3.1.3. Optimism, overconfidence and hubris ................................................................................................. 52 3.1.4. More on reference dependence .............................................................................................................. 53 3.2. Theoretical framework ................................................................................................................... 54 3.3. Empirical challenges ........................................................................................................................ 57 3.4. Investment policy .............................................................................................................................. 58 3.4.1. Real investment ............................................................................................................................................. 58 3.4.2. Mergers and acquisitions .......................................................................................................................... 62 3.5. Financial policy .................................................................................................................................. 65 3.5.1. Equity issues ................................................................................................................................................... 65 3.5.2. IPO prices ......................................................................................................................................................... 66 3.5.3. Raising debt .................................................................................................................................................... 67 3.5.4. Capital structure ........................................................................................................................................... 68 3.5.5. Contracting and executive compensation .......................................................................................... 69 4. Behavioral Signaling ................................................................................................................. 71 4.1. Theoretical Framework ................................................................................................................... 72 4.2. Applications ........................................................................................................................................ 77 4.2.1 Dividends ......................................................................................................................................................... 77 4.2.2. Other applications ........................................................................................................................................ 78 5. Conclusion..................................................................................................................................... 80 1. Introduction Corporate finance aims to explain the financial contracts and the real investment behavior that emerge from the interaction of managers and investors. A complete explanation of financing and investment patterns therefore requires a correct understanding of the beliefs and preferences of these two sets of agents. The majority of research
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