Behavioral Corporate Finance

Here one more interesting paper on Behavioral Corp Finance. Do managers always make rational decisions? Does group decision making have an amplification effect on irrational decision making?

Highly recommended!

Excerpt:

There are two key behavioral impediments to the process of value maximization, one internal to the firm and the other external. I call the first impediment behavioral costs. Behavioral costs tend to undermine value creation. They are the costs—or, alternatively, the loss in value—associated with errors that managers make because of cognitive imperfections and emotional influences. The second impediment stems from
behavioral errors by analysts and investors. These errors can create a wedge between fundamental values and market prices. Managers may then find themselves unsure of how to factor the errors of analysts and investors into their own decision-making.1

Consider first the behavioral obstacles to value creation that are internal to the firm. At present, academics and practitioners involved in issues of value-based management tend to focus exclusively on agency costs, which arise when the interests of agents (in this case, managers) are in conflict with the interests of the principals they have been engaged to serve (the owners or stockholders). Mechanisms that encourage agents to act in accordance with principals’ interests are said to be incentive compatible.

Proponents of value-based management emphasize that with properly designed incentives, managers will maximize the value of the firms for which they work. But behavioral costs can be quite large, and cannot be addressed though incentives alone. This is not to say that incentives are immaterial—on the contrary, incentives are of critical importance. The point, however, is that there are limits to what incentives can achieve. If employees have a distorted view of what is in their own self-interest, or if they have a mistaken view of what actions they need to take in order to maximize their self-interest, then incentive compatibility, although necessary for value maximization, will not be sufficient.

Now consider the behavioral obstacles to value creation that are external to the firm. Proponents of behavioral finance argue that risk is not priced in accordance with the CAPM and that market prices often deviate from fundamental values.
.....
The literature in behavioral decision-making suggests that people tend to be:
• loss averse;
• susceptible to framing or packaging that leads them to select inferior options;
• overconfident; and
• prone to confirmation bias.

The Economic Implications of Corporate Financial Reporting

This is a really cool paper on the factors that drive decision making on performance measurement and voluntary disclosure.

Excerpts

Our results indicate that CFOs believe that earnings, not cash flows, are the key metric considered by outsiders. The two most important earnings benchmarks are quarterly earnings for the same quarter last year and the analyst consensus estimate.
...
The severe stock market reactions to small EPS misses can be explained as evidence that the market believes that most firms can “find the money” to hit earnings targets. Not being able to find one or two cents to hit the target might be interpreted as evidence of hidden problems at the firm. Additionally, if the
firm had previously guided analysts to the EPS target, then missing the target can indicate that a firm is managed poorly in the sense that it cannot accurately predict its own future.
...
An overwhelming majority of CFOs prefer smooth earnings (versus volatile earnings). Holding cash flows constant, volatile earnings are thought to be riskier than smooth earnings. Moreover, smooth earnings ease the analyst’s task of predicting future earnings... A surprising 78% of the surveyed executives would give up economic value in exchange for smooth earnings.
...
Therefore, many executives feel that they are choosing the lesser evil by sacrificing long-term value to avoid short-term turmoil. In other words, given the reality of severe market (over-) reactions to earnings misses, the executives might be making the optimal choice in the existing equilibrium. CFOs argue that the system (that is, financial market pressures and overreactions) encourages decisions that at times sacrifice long-term value to meet earnings targets.
...
Companies voluntarily disclose information to facilitate “clarity and understanding” to investors. Executives believe that lack of clarity, or a reputation for not consistently providing precise and accurate information, can lead to under-pricing of a firm’s stock. In short, disclosing reliable and precise information can reduce “information risk” about a company’s stock, which in turn reduces the required return.
...
Several other broad themes emerge from our analysis. Corporate executives pay a lot of attention to stock prices, personal and company reputation, and predictability. Agency concerns, such as internal and external job prospects, lead executives to focus on personal reputation to deliver earnings and run a stable firm.
...
Executives believe that the market sometimes misinterprets or overreacts to earnings and disclosure announcements; therefore, they work hard to meet market expectations so as not to raise investor suspicions or doubts about their firms’ underlying strength.

Importance of Reported Earnings

CFOs state that earnings are the most important financial metric to external constituents ... One hundred fifty nine of the respondents rank earnings as the number one metric, relative to 36 top ranks each for revenues and cash flows from operations.
...
The interviews highlight four explanations for the focus on EPS. First, the world is complex and the number of available financial metrics is enormous. Investors need a simple metric that summarizes corporate performance, that is easy to understand, and is relatively comparable across companies. EPS satisfies these criteria. Second, the EPS metric gets the broadest distribution and coverage by the media. Third, by focusing on one number, the analyst’s task of predicting future value is made somewhat easier. The analyst assimilates all the available information and summarizes it in one number: EPS. Fourth, analysts evaluate a firm’s progress based on whether a company hits consensus EPS. Investment banks can also assess analysts’ performance by evaluating how closely they predict the firm’s reported EPS.

Earnings Benchmark
The survey evidence reported in Table 3 indicates that all four metrics are important: (i) same quarter last year (85.1% agree or strongly agree that this metric is important); (ii) analyst consensus estimate (73.5%); (iii) reporting a profit (65.2%); and (iv) previous quarter EPS (54.2%).

Stock price driven motication
The survey evidence is strongly consistent with the importance of stock price motivations to meet or beat earnings benchmarks. An overwhelming 86.3% of the survey participants believe that meeting benchmarks builds credibility with the capital market

Stakeholder motivations
Bowen, Ducharme and Shores (1995) and Burgstahler and Dichev (1997) state that by managing earnings, firms are able to enhance their reputation with stakeholders, such as customers, suppliers and creditors, and hence get better terms of trade. A statistically significant majority of the respondents agree with the stakeholder story (Table 4, row 6). Conditional analyses show that the stakeholder motivation is
especially important for firms that are small, in the technology industry, dominated by insiders, young, and not profitable. Perhaps suppliers and customers need more reassurances about the firm’s future in such companies.

Employee Bonuses
Consistent with the survey evidence, interviewed CFOs view the compensation motivation as a second-order factor, at best, for exercising accounting discretion. They tell us that companies often have internal earnings targets (for the purpose of determining whether the executive earns a bonus) that exceed the external consensus target... Furthermore, several interviewed CFOs indicate that bonuses are a function of an internal “stretch goal,” which exceeds the internal “budget EPS,” which in turn exceeds the analyst consensus estimates.

Career Concerns
The interviews confirm that the desire to hit the earnings target appears to be driven less by short-run compensation motivations than by career concerns. Most CFOs feel that their inability to hit the earnings target is seen by the executive labor market as a “managerial failure.” Repeatedly failing to meet earnings benchmarks can inhibit the upward or intra-industry mobility of the CFO or CEO because the manager is seen either as an incompetent executive or a poor forecaster.

Consequences of failure to meet earnings benchmarks
Several CFOs argue that, “you have to start with the premise that every company manages earnings.”...The common belief is that a well-run and stable firm should be able to “produce the dollars” necessary to hit the earnings target, even in a year that is otherwise somewhat down...As one CFO put it, “if you see one cockroach, you immediately assume that there are hundreds behind the walls, even though you may have no proof that this is the case.” Corporations therefore have great incentive to avoid the “cockroach” of missing an earnings benchmark.

Corporate Finance - Evidence from the field

A very interesting paper on practise of corporate finance by companies of different sizes, industries, capital structure, and management profile

Excerpts

Capital Budgeting:

We find that CEOs with MBAs are more likely than non-MBA CEOs to use net present value - but the difference is only significant at the 10% level.
...
Firms that pay dividends are significantly more likely to use NPV and IRR than are firms that do not pay dividends. This result is also robust to our analysis by size. Public companies are significantly more likely to use NPV and IRR than are private corporations.
...
Our finding that payback is used by older, longer tenure CEOs without MBAs instead suggests that lack of sophistication is a driving factor behind the popularity of the payback criterion.
...
The influence of leverage on the earnings multiple approach is also robust across size (i.e., highly levered firms, whether they are large or small, frequently use earnings multiples).

Cost of Capital

CAPM is by far the most popular method of estimating the cost of equity capital: 73.5% of respondents always or almost always use the CAPM....The second and third most popular methods are average stock returns and a multibeta CAPM, respectively.
...
Large firms are much more likely to use the CAPM than are smaller firms ... Smaller firms are more inclined to use a cost of equity capital that is determined by "what investors tell us they require." CEOs with MBAs are more likely to use the single factor CAPM or CAPM with extra risk factors than are non-MBA CEOs; but the difference is only significant for the singlefactor CAPM.
...
Overall, the most important additional risk factors are: interest rate risk, exchange rate risk,business cycle risk, and inflation risk. For the calculation of discount rates, the most important factors are interest rate risk, size, inflation risk, and foreign exchange rate risk. For the calculation of cash flows, many firms incorporate the effects of commodity prices, GDP growth, inflation and foreign exchange risk.

Interestingly, few firms adjust either discount rates or cash flows for book-to-market, distress, or momentum risks. Only 13.1% of respondents consider the book-to-market ratio in either the cash flow or discount rate calculations. Momentum is only considered important by 11.1% of the respondents.

Capital Structure

The tax advantage is most important for large, regulated, and dividend-paying firms – companies that probably have high corporate tax rates and therefore large tax incentives to use debt.
...
When we ask firms directly about whether potential costs of distress affect their debt decisions, we find they are not very important (rating of 1.24 in Table 6), although they are relatively important among speculative-grade firms. However, firms are very concerned about their credit ratings (rating of 2.46, the second most important debt factor), which might be an indication of concern about distress costs. Among firms that have rated debt and for utilities, credit ratings are a very important determinant of debt policy.
...
We ask directly whether firms have an optimal or "target" debt-equity ratio. Nineteen
percent of the firms do not have a target debt ratio or target range (see Figure 1G). Another 37% have a flexible target, and 34% have a somewhat tight target or range. The remaining 10% have a very strict target debt ratio. These overall numbers provide mixed support for the notion that companies trade off costs and benefits to derive an optimal debt ratio....Targets are important if the CEO has short tenure or is young, and when the top three officers own less than 5% of the firm. Finally, the CFOs tell us that their companies issue equity to maintain a target debt-equity ratio (rating of 2.26; row e of Table 8), especially if their firm is highly levered (2.68), firm ownership is widely dispersed (2.64), or the CEO is young (2.41).

Flexibility: The most important item affecting corporate debt decisions is management's desire for "financial flexibility,"
...
Internal funds deficit: Having insufficient internal funds is a moderately important influence on the decision to issue debt...More small firms (rating of 2.30) than large firms (1.88) indicate that they use debt in the face of insufficient internal funds, which is consistent with the pecking-order if small firms suffer from larger asymmetric-information-related equity undervaluation.
...
Equity undervaluation: Firms are reluctant to issue common stock when they perceive that it is undervalued...Rather than issuing equity when they feel it is undervalued, many firms issue convertible debt instead: Equity undervaluation is the second most popular factor affecting convertible debt policy (rating of 2.34 in Table 10), a response particularly popular among growth firms (2.72).
...
Market timing is especially important for large firms (2.40), which implies that
companies are more likely to time interest rates when they have a large or sophisticated debt issuance department. We also find evidence that firms issue short-term debt in an effort to time market interest rates. CFOs issue short-term when they feel that short rates are low relative to long rates (1.89 in Table 11) or when they expect long-term rates to decline (1.78).
...
We find moderate evidence that firms issue equity to dilute the stock holdings of certain shareholders (rating of 2.14 in Table 8). This tactic is popular among speculative-grade companies (2.24); however, it is not related to the number of shares held by managers. We also ask if firms use debt to reduce the likelihood that the firm will become a takeover target. We find little support for this hypothesis (rating of 0.73 in Table 6).
...
Among the 31% of respondents who seriously considered issuing foreign debt, the most popular reason they did so is to provide a natural hedge against foreign currency devaluation (mean rating of 3.15 in Table 7). Providing a natural hedge is most important for public firms (3.21) with large foreign exposure (3.34). The second most important factor affecting the use of foreign debt is keeping the source close to the use of funds (rating of 2.67), especially for small (3.09), manufacturing firms (2.92).
...
The most popular explanation of how firms choose between short- and long-term debt is that they match debt maturity with asset life (rating of 2.60 in Table 11). Maturity-matching is most important for small (2.69), private (2.85) firms.
...
Fourteen firms write that they choose debt to minimize their WACC
...
Among the 38% of firms that seriously considered issuing common equity during the sample period, earnings dilution is the most important concern affecting their decision...EPS dilution is a big concern among regulated companies (3.60), even though in many cases the regulatory process ensures that utilities earn their required cost of capital, implying that EPS dilution should not affect share price. Concern about EPS dilution is strong among large (3.12), dividend-paying firms (3.06).
...
We ask the executives whether the ability to call or force conversion is an important feature affecting convertible debt policy. Among the one-in-five firms that seriously considered issuing convertible debt, there is moderate evidence that executives like convertibles because of the ability to call or force conversion (rating of 2.29 in Table 10).

Source:
Graham, John R. and Harvey, Campbell R., "The Theory and Practice of Corporate Finance: Evidence from the Field" (December 1999). AFA 2001 New Orleans; Duke University Working Paper. http://ssrn.com/abstract=220251