BehavioralCorporateFinance:ACurrentSurvey
ForthcominginHandbookoftheEconomicsofFinance:Volume2
GeorgeM.Constantinides,MiltonHarris,andReneM.Stulz,Eds.
ElsevierPress,2012
MalcolmBaker
HarvardBusinessSchoolandNBER
BakerHall261
Boston,MA02163
617‐495‐6566
mbaker@hbs.edu
JeffreyWurgler
NYUSternSchoolofBusinessandNBER
44West4thSt,Suite9‐190
NewYork,NY10012
212‐998‐0367
jwurgler@stern.nyu.edu
Abstract: We survey the theory and evidence of behavioral corporate finance, which generally
takesoneoftwoapproaches.Themarkettimingandcateringapproachviewsmanagerialfinancing
andinvestmentdecisionsasrationalmanagerialresponsestosecuritiesmispricing.Themanagerial
biasesapproachstudiesthedirecteffectsofmanagers’biasesandnonstandardpreferencesontheir
decisions.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

ThissurveyupdatesandextendsasurveycoauthoredwithRickRubackthatwaspublishedintheHandbook
inCorporateFinance:EmpiricalCorporateFinance,editedbyEspenEckbo,in2007.Wethankhimforhis
manycontributionsthatcarriedovertothisversion,andwethankMiltHarrisforextensiveandhelpful
comments.BakergratefullyacknowledgesfinancialsupportfromtheDivisionofResearchoftheHarvard
BusinessSchool.
Table of Contents 1. Introduction...................................................................................................................................1
2. Markettimingandcatering......................................................................................................5
2.1. Backgroundoninvestorbehaviorandmarketinefficiency.................................................5
2.1.1. Limitedarbitrage............................................................................................................................................6
2.1.2. Categorizationandinvestorsentiment.................................................................................................8
2.1.3. Prospecttheory,referencepoints,lossaversion,andanchoring...............................................9
2.1.4. Smartmanagers............................................................................................................................................11
2.2. Theoreticalframework:Rationalmanagersinirrationalmarkets.................................12
2.3. Empiricalchallenges.........................................................................................................................18
2.4. Investmentpolicy...............................................................................................................................22
2.4.1. Realinvestment.............................................................................................................................................22
2.4.2. Mergersandacquisitions..........................................................................................................................25
2.4.3. Diversificationandfocus...........................................................................................................................27
2.5. Financialpolicy..................................................................................................................................28
2.5.1. Equityissues...................................................................................................................................................28
2.5.2. Repurchases....................................................................................................................................................33
2.5.3. Debtissues.......................................................................................................................................................34
2.5.4. Cross‐borderissues.....................................................................................................................................37
2.5.5. Financialintermediation...........................................................................................................................37
2.5.6. Capitalstructure...........................................................................................................................................41
2.6. Othercorporatedecisions.............................................................................................................43
2.6.1. Dividends.........................................................................................................................................................43
2.6.2. Earningsmanagement................................................................................................................................45
2.6.3. Firmnames......................................................................................................................................................47
2.6.4. Nominalshareprices..................................................................................................................................48
2.6.5. Executivecompensation............................................................................................................................49
3. ManagerialBiases......................................................................................................................50
3.1. Backgroundonmanagerialbehavior.........................................................................................50
3.1.1. Limitedgovernance.....................................................................................................................................50
3.1.2. Boundedrationality.....................................................................................................................................51
3.1.3. Optimism,overconfidenceandhubris.................................................................................................52
3.1.4. Moreonreferencedependence..............................................................................................................53
3.2. Theoreticalframework...................................................................................................................54
3.3. Empiricalchallenges........................................................................................................................57
3.4. Investmentpolicy..............................................................................................................................58
3.4.1. Realinvestment.............................................................................................................................................58
3.4.2. Mergersandacquisitions..........................................................................................................................62
3.5. Financialpolicy..................................................................................................................................65
3.5.1. Equityissues...................................................................................................................................................65
3.5.2. IPOprices.........................................................................................................................................................66
3.5.3. Raisingdebt....................................................................................................................................................67
3.5.4. Capitalstructure...........................................................................................................................................68
3.5.5. Contractingandexecutivecompensation..........................................................................................69
4. BehavioralSignaling.................................................................................................................71
4.1. TheoreticalFramework...................................................................................................................72
4.2. Applications........................................................................................................................................77
4.2.1 Dividends.........................................................................................................................................................77
4.2.2. Otherapplications........................................................................................................................................78
5. Conclusion.....................................................................................................................................80
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.
3
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
4
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.Itincludesfairlyconvincingevidenceofinefficienciesincluding
theJanuaryeffect;theeffectoftradinghoursonpricevolatility;post‐earnings‐announcementdrift,positive
autocorrelationinquarterlyearningsannouncementeffects,andmoregenerallydelayedreactiontonews;
momentum;Siamesetwinsecuritiesthathaveidenticalcashflowsbuttradeatdifferentprices;negative
“stub”values;closed‐endfundpricingpatterns;bubblesandcrashesingrowthstocks;relatedevidenceof
mispricinginoptions,bond,andforeignexchangemarkets;andinterestingnewpatternseveryyear.Thislist
excludesanomaliesrelatedtosecuritiesissuancethatwediscusslater.SeeBarberisandThaler(2003)and
Shleifer(2000)forclassicsurveysofthebehavioralfinanceandassetpricingliteraturemorebroadly.
6
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
7
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
9
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)showthatempiricalfeaturesofthedispositioneffectmake
ithardtoconnecttoprospecttheoryperse,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,havingpresidedoverarisein
thestockprice.Incontrast,imagineamoneymanagersells(short)thesamestockat$50.Thismightleadto
considerablelossesforthefirmandtheexecutive,anoutflowoffunds,and,ifthebetislargeenough,perhaps
theendofacareer.
5Conversely,whenthesharescrash,firmsserveasbuyersoflastresort(Hong,Wang,andYu(2008)).
11
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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f K ,  K ,
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
  ,
wheretheargumentsofdependonthenatureofprevailinginvestorsentiment.Thearguments
mightincludeinvestinginaparticulartechnology,assumingaconglomerateorsingle‐segment
structure,changingthecorporatename,managingearnings,initiatingadividend,splittingshares,
andsoon.Inpractice,thedeterminantsofmispricingmaywellvaryovertime.
Thethirdgoalistoexploitthecurrentmispricingforthebenefitofexisting,long‐run
investors.Managersachievethisbya“markettiming”financingpolicywhichsuppliessecurities
thataretemporarilyovervaluedandrepurchasesthosethatareundervalued,oratleastless
overvalued.Thispolicytransfersvaluefromthenewortheoutgoinginvestorstotheongoing,long‐
13
runinvestors;thetransferisrealizedaspricescorrectinthelongrun.6Forsimplicity,wefocus
hereontemporarymispricingintheequitymarkets,andsoreferstothedifferencebetweenthe
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,wearealsousingthemarketinefficiencyassumptionhereinassumingthatmanagerialeffortsto
captureamispricingdonotfullyandinstantlydestroyitintheprocess,astheydointherationalexpectations
worldofMyersandMajluf(1984).Inotherwords,investorsunderreacttocorporatedecisionsdesignedto
exploitmispricingbecauseoflimitedarbitrage,attention,etc.
7Forlongrunshareholderstobenefit,weareimplicitlythinkingofsomethinglikethree‐periodmodel.Inthe
firstperiod,investmentandfinancingdecisionsaremade,andpricesareabovefundamentalvaluebyan
amount.Thereisanintermediateperiodwherepricesdonotchange,butshort‐runinvestorsselltheir
shares,andafinalperiodwherefundamentalvalueisrealized.Issuingequitywilltheeffectofreducingprices
inthefirstandsecondperiodsife<0,whileincreasingthevaluepershareinthethirdperiodfromwhereit
wouldotherwisebe.
8Forexamples,seeStein(1989)andScharfsteinandStein(1990).Foracomparisonofrationalexpectations
andinefficientmarketsinthisframework,seeAghionandStein(2008).
14
Puttingthegoalsoffundamentalvalue,catering,andmarkettimingintooneobjective
function,wehavethemanagerchoosinginvestmentandfinancingto
max   f K ,  K  e   1     ,
K ,e
whereisgreaterthanzeroandlessthanorequaltooneandspecifiesthemanager’shorizon.
Whenequalsone,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:
f K K ,  1  e  1  K  ,and
 f e K ,     e  1  e  .
Thefirstconditionisaboutinvestmentpolicy.Themarginalvaluecreatedfrominvestment
isweighedagainstthestandardcostofcapital,normalizedtobeonehere,netoftheimpactthat
15
thisincrementalinvestmenthasonmispricing,andhenceitseffectthroughmispricingoncatering
andmarkettiminggains.Thesecondconditionisaboutfinancing.Themarginalvaluelostfrom
shiftingthefirm’scurrentcapitalstructuretowardequityisweighedagainstthedirectmarket
timinggainsandtheimpactthatthisincrementalequityissuancehasonmispricing,andhenceits
effectoncateringandmarkettiminggains.Thisisalottoswallowatonce,soweconsidersome
specialcases.
Investmentpolicy.InvestmentandfinancingareseparableifbothKandfeKareequalto
zero.ThentheinvestmentdecisionreducestothefamiliarperfectmarketsconditionoffKequalto
unity.Notethat,iffeisequaltozero,thereisnooptimalcapitalstructure.Realconsequencesof
mispricingforinvestmentariseintwoways.Eithercapitalstructurehasarealeffectonvalue,when
f e and f eK arenotequaltozero,orinvestmenthasadirecteffectonmispricing,when  K isnot
equaltozero.Thesimplestsituationtoevaluateinthefirstcasehas  K and  e equaltozero.The
simplestsituationtoevaluateinthesecondcaseiswhen f e 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,
16
whichisnecessaryforaninteriorsolutionforinvestment.)Insum,becauseofundervaluationand
financialconstraints,themanagerchoosesacombinationoflowerequityissueseandlower
investmentKthanhewouldinthesituationofnomispricing.
InPolkandSapienza(2009)andGilchrist,Himmelberg,andHuberman(2005),thereisno
optimalcapitalstructure,butKisnotequaltozero:mispricingisitselfafunctionofinvestment.
Thepotentialtocreatemispricingdistortsinvestmentinasimple,directway.PolkandSapienza
focusoncateringeffectsanddonotconsiderfinancing(eequaltozerointhissetup),whileGilchrist
etal.modelthemarkettimingdecisionsofmanagerswithlonghorizons(equaltoone).
Financialpolicy.Thedemandcurveforafirm’sequityslopesdownunderthenatural
assumptionthateisnegative,e.g.,issuingsharespartlycorrectsmispricing.9Wheninvestmentand
financingareseparable,managersactlikemonopolists.Thisiseasiesttoseewhenmanagershave
longhorizons,andtheyselldownthedemandcurveuntilmarginalrevenueisequaltomarginal
cost–ee.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)).
10Totalmarkettiminggainsmaybeevenhigherinadynamicmodelwheremanagerscansellinsmall
incrementsdownthedemandcurve.
17
Othercorporatedecisions.Thisframeworkcanbeexpandedtoaccommodatedecisions
beyondinvestmentandissuance.Considerdividendpolicy.Increasingorinitiatingadividendmay
simultaneouslyaffectbothfundamentalvalue,throughtaxes,andthedegreeofmispricing,if
investorscategorizestocksaccordingtopayoutpolicyastheydoinBakerandWurgler(2004a).
Thetradeoffis
 f d K ,  e  1  d  ,
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
18
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.
19
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
20
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.
21
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
whenKisgreaterthanzeroabove).Investorsmayoverestimatethevalueofinvestmentin
particulartechnologies,forexample.Second,afinanciallyconstrainedfirm(thiscanhappenwhen
feKisgreaterthanzeroabove)maybeforcedtopassupfundamentallyvaluableinvestment
opportunitiesifitisundervalued.
22
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
23
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‐tech
firmsissuedequityduringtheInternetbubbleandusedittoinvest.Theunconstrainednon‐techfirmsdidnot
showthispattern.Thissuggestthatbubblesdrivenbyonecategorycanhavepositivespillovereffectson
relativelyunrelatedfirms.
24
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‐basedexplanationof
thislink.
13ArelatedpredictionoftheShleifer‐Vishnyframeworkisthatanovervaluedacquirercreatesvalueforlong‐
termshareholdersbyacquiringafairlyvaluedorsimplylessovervaluedtarget.SavorandLu(2009)tests
thispropositionbycomparingthereturnsofsuccessfulacquirerstothosethatfailforexogenousreasons,
25
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),but
unsuccessfulacquirersperformevenworse.
14Forexample,inthecaseofS&P100firmsover1999‐2001,FamaandFrench(2005)findthattheamountof
equityraisedinmergersisroughly40timesthatraisedinSEOs.
26
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
27
(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)writesthat
thecompanyspentsomeeffort“toverifythedominanttrendsininvestorperceptionsofcorporateefficiency,
asseeninthecompanystudyoftheimpactofexcessivediversificationonthetrendofprice‐earnings
multiplesinthe1970s”(p.140).
28
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’swebsiteat
http://bear.warrington.ufl.edu/ritter/ipodata.htm.
29
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:whileIPOshave
lowabsolutereturns,andlowreturnsrelativetomarketindexes,theyoftendonotdoworsethanstocksof
similarsizeandbook‐to‐marketratio.Oneinterpretationisthatsecuritieswithsimilarcharacteristics,
whetherornottheyareIPOs,tendtobesimilarlypriced(andmispriced)atagivenpointintime.
30
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.”Amoreplausibleexplanationisthatbroadwavesofinvestor
sentimentleadmanyfirmstobemispricedinthesamedirectionatthesametime.Then,theaverage
financingdecisionwillcontaininformationabouttheaverage(i.e.,market‐level)mispricing,eventhough
individualmanagersareperceivingandrespondingonlytotheirownfirm’smispricing.
19Butler,Grullon,andWeston(2005)takeSchultz’sideatothetime‐seriesandarguethattheequityshare’s
predictivepowerisduetoanaggregateversionofthepseudomarkettimingbias.Baker,Taliaferro,and
Wurgler(2006)replythatthetestsinButleretal.havelittleactualrelevancetothebiasandthatstandard
econometrictechniquesshowthatsmall‐samplebiascanaccountforonlyonepercentoftheequityshare’s
actualpredictivecoefficient.
31
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.
32
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.
33
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
34
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
35
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
36
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,soGrahamandHarveydonot
askaboutthedeterminantsofinternationalstockissues.
37
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.
38
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
39
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.
40
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‐raising
needsanddebtmarketconditionslikethetermspread.
41
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.
42
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,unlikea
repurchase,pro‐ratadividendsdonotchangetheownershipstructureofthefirm,andthereisnomarket
timingbenefitorcost.Forthisreason,itfitsmorenaturallywiththecategoryofcorporatedecisionsthat
mightinfluencethelevelofmispricing,butdonotbythemselvestransfervalueamonginvestors.
43
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.
44
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.
45
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
46
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
47
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
48
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)arguethatrationalmanagersmayminimizecostsbypayingoptimisticemployeesinovervalued
equity,intheformofoptionsgrants.Benartzi(2001)offersafoundationforthissortofoptimism,showing
thatemployeeshaveatendencytoextrapolatepastreturns,andasaconsequenceholdtoomuchcompany
stock.SeealsoCoreandGuay(2001)andOyerandSchaefer(2005).
49
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)discusstheimpactoflessthanfully
rationalbehavioronotherpartsoforganizations.
50
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
51
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
52
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.
53
Forthemoment,weuseoverconfidence,insteadofreferencepoints,asanexampleofan
organizingframeworkinthenextsection.Thesectiononbehavioralsignalingattheendofthe
surveywilldevelopamodelusingreferencepoints.
3.2. Theoretical framework ThederivationbelowisinthespiritofHeaton(2002)andMalmendierandTate(2005),
modifiedtomatchthenotationinthemarkettimingandcateringmodelasmuchaspossible.We
assumethemanagerisoptimisticaboutthevalueofthefirm’sassetsandinvestmentopportunities.
Hebalancestwoconflictinggoals.Thefirstistomaximizeperceivedfundamentalvalue.Tocapture
this,weaugmentfundamentalvaluewithanoptimismparameter,
1    f K ,  K ,
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
believesthatthefirmisundervaluedbyf,andthusinsellingafractionofthefirmeheperceives
thatexisting,long‐runshareholderswilllose
ef K , .
54
Puttingthetwoconcernstogether,theoptimisticmanagerchoosesnewinvestmentand
financingtosolve
max1    f K ,  K  ef K , .
K ,e
Wedonotexplicitlyincludeabudgetconstraint.Instead,againtokeepthenotationsimple,we
consideritsreduced‐formimpactonf.
DifferentiatingwithrespecttoKandegivestheoptimalinvestmentandfinancialpolicyof
anoptimisticmanageroperatinginefficientcapitalmarkets:
f K K , 
1
,and
1  1  e 
1    f e K ,    f K ,  ef e K , .
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.
55
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
56
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
57
max1    f K   K  ce  ,
K ,e
wherereflectsthepreferenceforortheprivatebenefitsthatcomewithpresidingoveralarger
firm,asinJensenandMeckling(1976)orGrossmanandHart(1988),ratherthanoptimism.
Rationalinvestorsrecognizetheagencyproblemupfront,socreflectsthecostofraisingoutside
equity,andmanagementandexistingshareholdersbeartheagencycosts.
Thisreducedformisalmostidenticaltotheobjectivefunctionofanoptimisticmanager.
Bothcangenerateoverinvestment,underinvestment,cashflow‐investmentsensitivities,pecking
orderfinancing,andsoforth.Moreover,Steinpointsoutthattheagencymodelisitselfhardto
distinguishfrommodelsofcostlyexternalfinancebuiltonasymmetricinformation.Thus,totest
thebehavioraltheories,onemustseparatetherelatedtooverconfidenceandoptimismfromthe
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.”
58
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‐moneyoptionsisnotsignificantly
relatedtofutureabnormalstockreturns,supportingtheirassumptionthatsuchbehaviorindeedreflects
optimismratherthangenuineinsideinformation.SenandTumarkin(2010)modeltheCEO’sportfoliochoice
andoptionexerciseprobleminmoredetailandarguethatamorerobustmeasureofoptimismissimply
whethertheCEOsellsorretainsthesharesreceiveduponexercise.SeeGiderandHackbarth(2010)foran
overviewofoptimismandoverconfidenceproxies.
59
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
60
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.
28Agoodquestioniswhethertheuseofsuchrulesisbetterunderstoodasanagencyproblemthanas
boundedrationality.Thatis,executivesmightusesimplerulestoshortentheworkdayandsavetimeforgolf.
However,GrahamandHarveyfindthathigh‐ownershipmanagersareifanythinglesslikelytouseNPVand
morelikelytousethepaybackperiodrule.
61
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
62
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).
63
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,othersrepresentinvestorbiasesandthus
theevidencebelowcouldalsobeincludedinourearliersectionsaboutinvestorirrationality.
64
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
65
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,perhapsbecauseitgenerates
profitablerent‐seekingactivitiesamonginvestors,e.g.tradingwiththeunderwriter’sbrokeragearm,or
becauseitreducesmarketingcosts.
66
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)foranalternativeexplanationforthisasymmetrybasedoninformation
gatheringinthebook‐buildingprocess,andEdelenandKadlec(2003)foronebasedonsampletruncation
biasrelatedtothewithdrawlofIPOswhoseprospectsdeteriorateduringthewaitingperiod.
67
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.
68
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.Theyfocusonthe
overallefficiencyofthecreditmarket.
69
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.
70
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.
71
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
72
a$0.01dropindividendsjustbelowthereferencepointisgreaterthanthepositiveeffectofa$0.01
increaseindividendsjustabove.Thesecondkeyingredientisthatthemanagercaresaboutthe
currentestimateoffirmvalueaswellasthelong‐termwelfareofinvestors.
Themodelfocusesontwoperiods:t=1and2.Therearetwoplayers:abenevolent
managerandaninvestortowhomdividendcutsfromthecurrentreferencepointlevelare
discontinuouslypainful.Inthefirstperiod,theinvestorarriveswithanexogenousreferencepoint
d*.Themanageralsoreceivesprivateinformationaboutcashearnings1andpaysadividendd1in
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:
73
Managerutility.Themanagercaresaboutwhattheinvestorthinksabout1todaybecause
thatdeterminestoday’sstockprice.Healsocaresabouttheinvestor’slongrunutility.The
simplifiedobjectivefunctionis:



E m  Ei  1   1   u d1 , d 2 | d * ,
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
1appearsdirectlyintothemanager’sobjectiveisaninnocuous
assumption,becauseinequilibriumthestockpricewillbealineartransformationofthisexpectation.
35Thefactthattheinvestor’sexpectationof
74
pointappliedtototalendingwealth,butmuchmorenarrowlybothacrossstocksandtime,inthe
spiritofBarberis,Huang,andThaler(2006).
Information.Forsimplicity,themanagerhasnocontroloverthecashearningsofthefirm.
Thisisabitdifferentfromatraditionalsignalingmodelwherethemanagermustdestroyfirmvalue
toimpressthecapitalmarkets.Thereisalsonoagencyproblem;themanagerisnotabletokeepthe
cashforhimself,andnorealvalueiscreatedordestroyedwithdividendpolicy.Thefundamental
valueofthefirmappearsintwoinstallmentsandtotals 1   2 .Thinkoftheseascashearningsthat
arenotobservabletotheinvestor.Thisisanextremeassumptionofasymmetricinformationthat
highlightstheintuition.Forsimplicity,assumethatthesecond‐periodcashearningshaveauniform
distribution,  2 ~ U 0,2 .
Budgetconstraint.Thereisnonewequityordebtavailabletofinancethepaymentof
dividendsandnoexcesscashbalancesavailableinthefirstperiod.Themostthemanagercanpay
inthefirstperiodis1,andthemosthecanpayinthesecondperiodis2plusanysavingsfromthe
firstperiod.Givenabenevolentmanagerandtheabsenceofnewfinancing,thisimpliesconstraints:
0  d1   1 and d 2   1   2  d1 .
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,
75
increasingthedividendinthefirstperiod,foreitheroftheserationales,producesanexpected
futurecosttoinvestorutilitythatcomesfromthepossibilityoffallingshortofthereferencepoint
setforthesecondperiod.
Thesethreemotivationscombinetosimplifythemanager’sutilityfunction:
2

  

1   b  d1  d * d1  d *   Ei 1 | d1   1   b  d1  1  d1  1 
2
2
Thefirsttermreflectsstrivingtoavoidfallingshortoftheinitialreferencepoint.Thesecondterm
reflectsconcernaboutshareprice.Thethirdtermreflectstheexpectedcostoffallingshortofanew
referencepoint;thereisnocostifthemanageradoptsaveryconservativedividendpolicyofpaying
halfoffirst‐periodearnings.Giventheuniformdistributionof2,theexpectedcostisquadraticas
dividendsrisefromthispointandincreasingintheintensityofthereferencepoint.
Intuitively,theseconsiderationssuggestthreerangesofdividendpoliciesinequilibrium.
Thereisahighpayoutratioforfirmswiththeextramotivationduetosignalingtocleartheinitial
referencepointofd*.Next,managersclusteratd*oncethismarginaleffectdropsout,i.e.they
maintaintheirexistingdividendlevelexactly.Finally,thereisalowerpayoutratioforfirmswith
first‐periodearningswellabovetheinitialreferencepoint.Theseluckyfirmsnonethelesspay
higherdividendstoseparatethemselvesfromeachotherandfromthepoolatd*.Specifically,there
existsanequilibriumwhere:
d1=1if1<d*,
=d*ifd*<1<*,and
= 12 1  1  1b if1>*,
76
with*satisfying  12  *d *  1   b


1

 1b    d *  12  *  0 ,
2
2
and equilibrium beliefs of: Ei[1 | d1]= d1 if d1 < d*,
=
1
2
 *  d * if d1 = d*,and
= 2  d1  1  1b  if d1 > 12  * 1  1b .
Thereareintuitivecomparativestaticswithrespecttob,thecostoffallingbelowthe
referencepoint.Inthisequilibrium,itcanbeshownthatasbincreasesanddecreases,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.
77
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
78
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.proposethatexecutivesthemselvesmayderivepersonalutilityfrom
meetingthresholds.
79
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?
80

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
81
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
82
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?
83
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