Bachelor
Thesis
Author:
Pieter Vermaas, 358804
Supervisor:
Prof. dr. J.T.J. Smit
University:
Erasmus University Rotterdam
Faculty:
Erasmus School of Economics
Year:
2014
[COULD REAL OPTIONS BE THE SOLUTION
FOR OVER- AND UNDERVALUATION IN HOT
AND COLD DEAL MARKETS?]
An experiment to test whether prior business experiences influence valuations due to cognitive biases
and whether receptivity for the use of real exists
Key words: M&A, Biases, Debiasing, Real options, Experiment
Table of Contents
Introduction ..................................................................................................................... 3
Theoretical Framework ..................................................................................................... 6
Valuation Methods .............................................................................................................................. 7
Cognitive Biases ................................................................................................................................... 9
Anchoring ........................................................................................................................................ 9
Over-optimism/Overconfidence .................................................................................................... 11
Relation temperature of the market and overconfidence ............................................................. 17
Loss Aversion ................................................................................................................................. 19
Relationship temperature of the market and loss aversion .......................................................... 20
Narrow framing ............................................................................................................................. 22
Summary – Hypothetical relation between market temperature and valuations ........................ 24
Real options as a solution for static DCF valuations.......................................................................... 28
Real options ................................................................................................................................... 31
Experiment ..................................................................................................................... 33
Conclusion ...................................................................................................................... 40
Appendix : Experiment .......................................................................................................................... 43
Bibliography........................................................................................................................................... 51
2
Introduction
How could one explain that CEOs of competing companies are queuing up to acquire the same
targets when they know that prices are high, whilst the same CEOs shy away from comparable
targets when prices are low? Does the underlying value of these targets really differ that much over
different points in time, or is it possible that valuations are biased? If so, is this not paradoxical since
CEOs are in that position because they are supposed to value potential investment opportunities
objectively and independently? Research has shown that because of framing effects on the valuation
of investment opportunities by executives, valuations indeed appear to be biased in different phases
of the business and M&A cycle. Apparently executives tend to be optimistic about a target’s potential
during upward fluctuations in the business cycle, which results in heavy competition for take-over
targets with high prices and ultimately many deals being done. Inversely, executives seem to be
reticent during downward fluctuations, which results in few deals being done whilst prices are
relatively low. These market situations can be described as ‘hot’ and ‘cold’ deal markets (as proposed
by Smit & Lovallo (2014)). One of the problems which may partially be a result of deals done in a hot
deal market, is the vast amount of deals that later turn out to be failures, with substantial problems
for society (Camerer & Lovallo, 1999) & (Financieel Dagblad, 2014). However, this is not the sole
problem related to fluctuations in the amount of deals. When executives decide to acquire targets
because of over-optimism, and this is done on a large scale, this might lead to a market which is
excessively concentrated. The related consequences are widely known: less competition and
potential lasting changes in the market structure. For society, competition leads to more efficient
outcomes. A cold market also gives rise to various problems, the most predominant of which is
forfeited economic value due to good deals going to waste.
Given the problems described above it is evident that solutions to this hot and cold deal market
phenomena should be subject to research. Among others, Smit & Lovallo (2014) and Smit & Moraitis
(2010) have treated this subject and provide a possible solution in the form of real options. By using
the real options approach as an addition to conventional valuation methods, they see a way of
correction for over- and undervaluation in respectively hot and cold deal market situations. As earlier
mentioned, over- and undervaluation could be the result of executives’ over-optimism and
overconfidence in a hot market situation and reticence in cold deal markets, which, in turn, may be
the consequence of earlier experiences. When using the DCF method, the above is illustrated by
executives’ potential exuberance of the horizon value in a hot deal market, as they focus too much
on growth possibilities. In a cold deal market, executives focus too much on the risk of an investment
and therefore the initial outlay, whilst little attention is paid to the horizon value. Combined with
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executives’ perceptions of the possible investment as a ‘Go-or-no-Go decision’, this results in a static
valuation which could lead to biases in the valuation of this possible acquisition.
Smit & Moraitis (2010) distinguish various ways of how these biases could influence the valuation.
Anchoring and overconfidence could be reasons for overvaluation in hot deal markets. In cold deal
markets anchoring, narrow framing and loss aversion could explain why executives are reluctant to
invest or undervalue targets. The experiment solely tests if potential differences in the valuation
during hot and cold deal market settings are the result of overconfidence and a combination of
narrow framing and loss aversion. More specific, the goal of the experiment is to test whether a
difference in valuation following a divergent prior business experience occurs and whether the
implementation of real options could provide a solution, which is manifested if participants are able
to recognize the setting in which real options are embedded. The question which bias is the real
cause of the potential difference in the valuation between executives in a hot and cold deal market,
or which one outweighs the other potential bias, is therefore also relevant. In order to answer these
questions, an important assumption has to be made: M&A market activity (in the rest of this paper
also referred to as the temperature of the M&A market) is related to the state of the
economy/business cycle (Becketti, 1986); (Harford, 2005); (Andrade & Stafford, 2004). Consequently,
the possible event that executives’ valuations vary in different states of the M&A market, could be
caused by prior business experiences which are associated to these different states of the M&A
market. In short, a hot deal market is assumed to be accompanied by experiences of an economic
upturn, whilst a cold deal market is assumed to be accompanied by experiences of an economic
downturn. An additional assumption is that the aggregated economic conditions are positively
correlated to a company’s prior business successes. This assumption is made, since the hypotheses of
the experiment are based on personal-level biases.
The reasoning behind the solution for the influence of biases on the valuation process as proposed
by Smit & Lovallo (2014) is basically as follows. The aforementioned over-optimism by executives in
hot deal markets should be tempered by instilling caution via real options, which should offset the
causes and amplifying factors of over-optimism, such as the ‘illusion of control’. The kind of real
options that could prove valuable in this sense are the so called options to defer or stage investment.
This basically means that executives should sometimes wait investing rather than perceiving an
investment opportunity as ‘now or never’/’Go-or-no-Go’ and consequently be better off. By using a
wait-and-see strategy the downside risk will be weakened. For the executives’ pessimism, inherent in
cold deal markets, a sense of venturing has to be conveyed, once again via real options. The most
important real options in this regards are the growth options, options to switch as well as
abandonment options. These options are often present in investment opportunities, yet they are
4
overlooked by executives because of a narrow frame. By increasing the awareness of executives that
these options exist and are embedded in investment opportunities, the valuations of such projects
should increase and the focus on risk reduce.
The statements made by Smit & Lovallo (2014) that in a hot deal market executives focus too much
on growth, whilst in a cold deal market too much on risk, result in the conclusion that valuations of
executives framed in a hot deal market should differ from valuations made by executives framed in a
cold deal market if the valuated venture is the same. This paper offers a form to empirically test
whether this conclusion is true and if real options could change this. The actual empirical test will be
carried out in future research. The first step in this experiment is to test whether a difference in
valuations occurs when participants are confronted with a hypothetical venture and framed in a
situation of an economic up- or downturn in both the financial market and in their company’s
performance. The valuation is based on the discounted cash flow method. The described venture
should embed the possibility for participants to perceive growth options. Subsequently, in order to
test if real options could be a solution for the potential difference, certain important characteristics
inherent to real options will be made explicit. The kind of real options depends on the market setting
in which the participants earlier have been framed. These questions provide the opportunity to see
whether participants are able to recognize the use of real options and, since they should alter the
valuation consequently. For both the group of participants framed in a hot deal market and the
group of participants framed in a cold deal market, a control group is formed. The same questions
are posed to these control groups. They only differ from the other participants in the way that they
are not initially framed. In other words, are not presented with a prior business involvement.
The above leads to the following question:
Are executives able to recognize the existence of real options in order to alter their valuation of
investment opportunities during a hot and cold deal market?
The structure of this paper is as follows. Firstly, the theoretical foundations of the experiment will be
discussed. This will be done by a justification and explanation of the hypotheses. To begin with a
short explanation of the application of the conventional valuation methods: DCF and multiples
analysis. Secondly, the relevant cognitive biases will be described. Next, the hot and cold deal market
phenomena will be treated, with emphasis on the causes of these occurrences, after which a clear
delineation will be made as to which reasons will be considered in this paper. After this, a
combination of the DCF, the relevant cognitive biases as well as the relevant reasons will be made,
aiming to properly describe the problem and thereby making clear what possible solutions the
composed experiment seeks for. Successive to this, the relevant real options will be described.
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Thereafter, the problem will be regarded in the light of these real options in order to explain how
these options can theoretically provide a solution. In the line of this theoretical foundation, four
hypotheses will be constructed, which will serve as propositions the experiment to be composed
seeks to test. As the theoretical considerations underlying the experiment have been thoroughly
explained, the experiment section of the paper will be concerned with a step-by-step explanation of
the formulation and composition of the experiment. The conclusion of this paper will summarize the
considerations underlying the composition of the experiment, as well as to give some suggestions
and points of improvement that should be regarded when composing an experiment regarding this
issue.
Theoretical Framework
As earlier mentioned, the goal of this research is to construct an experiment which tests whether
there is a difference in the valuation of an equal investment opportunity as a consequence of the
condition of the economy in which the executives frame investment opportunities, as well as
whether the participants are receptive for the use of real options. The experiment used to test the
above is based on certain theoretical hypotheses. These hypotheses should be linked in order to
explain the feasible valuation differences. The first hypothesis is as follows:
Hypothesis I:
Participants’ valuations of an identical investment opportunity with the use of the DCF method, are
higher when confronted with earlier business successes (hot deal market) compared to a situation of
earlier business setbacks (cold deal market).
In the first part of the experiment, the participants are assigned to different groups. Participants of
two groups are confronted with a history of respectively increased and decreased company values,
as a vague result of economic conditions and former investment decisions. Because of various
reasons, which will be elaborated in the sequel of this paper, these valuations could differ. In the
following part of the experiment the participants will be subject to distinctive experimental
manipulations based on their business experiences. Because of these manipulations, a further
comparison between the valuations made in the two groups will be invalid. Furthermore, two control
groups are imposed, partly in order to test for sample reliability (e.g. outliers) and to anticipate
further problems with inference. The control groups for both the group which encountered a positive
history and the group which encountered a negative history are only given an initial company value.
The expectation is that the average valuations of these groups do not differ, which might be contrary
6
to a comparison between the control groups and the groups which are initially framed. Furthermore,
a comparison between the initial valuations of the ‘framed’ groups and their control groups, provides
the opportunity to test which biases are involved. The above leads to the following hypotheses:
Hypothesis II:
Participants’ valuations of an identical investment opportunity with the use of the DCF method, are
higher when confronted with earlier business successes (hot deal market) compared to a situation
without any given previous business involvement
Hypothesis III:
Valuations of an investment opportunity by participants who are confronted with earlier business
setbacks (cold deal market) differ from valuations of an identical opportunity by participants who
have no earlier business involvement.
In order to justify above hypotheses certain implied questions has to be answered. What kind of
investment opportunity is meant? What is the nature of the DCF method and how could the assumed
difference in valuations be explained? The answer on the first question is related to the use of real
options. In order to test whether participants neglect certain aspects of an investment opportunity,
which could be offset by the use of real options, the description of the investment target must allow
space for interpreting opportunities to grow/expand, stage and/or abandon the investment. The
relationship between the characteristics of the investment opportunity and the applied real options
will be clarified in a following part of the theoretical framework. As earlier introduced, the assumed
reason of the dependence of executives’ (here participants’) valuations on the context of earlier
experiences and the associated possible difference, are due to various cognitive biases. First these
biases will be discussed in order to elaborate on the relationship between these biases and the
condition of the M&A market. In other words; in which scenarios are executives more prone to which
biases and how could one explain this?
Valuation Methods
There are various methods to value a company, of which many could be subject to biases. One of the
prevailing methods is the discounted cash flow method. This method is characterized by discounting
future cash flows which are plausibly certain, by mostly the weighted average cost of capital. Cash
flows with a certain degree of certainty can only be estimated for a finite period. The economic value
of the cash flows after this period (planning period) can be estimated with a horizon/terminal value.
A substantial part of value derived from the discounted cash flow method is based on this horizon
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value. Combined with the arbitrary nature of the determination of the horizon value, this makes the
valuation of a target based on the discounted cash flow method sensitive for under- or overvaluation
as a result of biases. Furthermore, there are various ways to determine the horizon value. One of
these methods is the perpetuity growth model. By determining the present value of the sum of the
future uncertain cash flows after correction for the expected growth, one can add this value to the
net present value of the cash flows in the planning period to get the total value as a result. Certain
assumptions have to be made. One of them is the assumption that the used growth rate is constant.
This could lead to a misrepresentation of the real value in case the future cash flows are not to be
expected to grow constantly. Furthermore, an overoptimistic estimation (even narrowly) of the
growth rate could have large consequences, as the conclusion of an analysis based on the DCF
method is often binary; invest or not invest. Another widely used method to determine the horizon
value is the exit multiple approach. The concept of multiples and the use for valuation will shortly be
discussed in the sequel of this theoretical framework, but is also relevant to the valuation of the
horizon value. The approach is characterized by the creation of a hypothetical situation of selling the
investment opportunity at the end of the planning period. The value at that moment is calculated
with an exit multiple, for example: enterprise value / EBITDA. This multiple is based on corresponding
market acquisitions. Again the calculated value at the end of the planning period should be
discounted and be added up to the net present value of the cash flows in the planning period. The
use of exit multiples could also result in a misrepresentation of the real value, because the multiples
based on comparable acquisitions could be wrenched. The exit multiple could also be related to an
entry multiple. In case of erroneous entry multiples; this results in a misrepresented valuation (Smit
& Moraitis, Playing at serial acquisitions, 2010). Summarized, both methods which can be used to
calculate the horizon value, could be biased because of the interpretation of uncertainty.
Another commonly used method to value possible targets is the multiples method. In the experiment
participants will be provided with information to use the DCF method, instead of the multiples
method. However, since the multiples method is widely applied, independently or as a tool to control
the outcome of the DCF method, potential biases could offset or enhance the conclusion made of a
valuation based on the DCF method, and therefore requires a brief consideration. For example, if the
use of the multiples method is prone to the same biases as potential biases made with the DCF
method, and these biases may occur in the same economic context, this could confirm the under- or
overvaluation made by executives. Put simply, the multiples method is the process of selecting
comparable acquisitions and calculating corresponding statistics, in order to make a market based
valuation. Problems could arise when one selects the wrong peers or multiples or does not make
sufficient adjustments. The latter subject will be further discussed in the next section.
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Before a consideration about potential executives’ cognitive decision-making problems is made, the
influence of these executives, in particular the chief executive officers, on the valuation and
ultimately the bidding process has to be considered. After identifying potential investment targets,
the top management has to come up with an offer price. Because most acquisitions have a major
impact on a company’s future, the board of directors has to approve the offer price. However, the
CEO has an important role in the negotiations between a target and the potential acquirer, and could
in addition persuade the board of directors. Often the board of directors are prone to adapt the offer
price made by a CEO (Mace, 1971).
Cognitive Biases
The view that people are not fully capable to process relevant information concerning a decision
immediately and in a structured way, is well known. Simon (1955) was the first to adress this
experience as bounded rationality. In situations of decision-making people make use of heuristics in
order to process the relevant information. The previous cited scholar Simon (1990) describes
heuristics as ‘methods for arriving at satisfactory solutions with modest amounts of computation’,
simply stated; cognitive decision rules. These decision rules or ‘rules of thumb’ are by definition not a
problem, however they often result in biases; the propensity to make errors systematically. Both the
DCF and multiples method are sensitive to these biases. Therefore various biases will be discussed, as
well as their relationship with prior business experiences in furtherance of explaining the potential
difference between valuations during a hot and cold deal market. The essence of certain biases might
correspond to other described biases in behavioral literature (Shah & Oppenheimer, 2008). However,
a thorough description of all the possible biases in which the behavior of executives could be
categorized, is beyond the goal of the experiment. It is important to indicate which tendencies
executives might possess and which circumstances might influence these tendencies.
Anchoring
In situations characterized with uncertainty, estimations are often based on a certain starting or
reference point. If the reference point of an estimation changes, the estimation might also alter
toward the reference point, without a shift in the probabilities which could underlie this change. A
well known experiment executed by Tversky & Kahneman (1974) tested the above by asking
participants to estimate the number of African countries that are a member of the United Nations.
Before the participants could guess, a wheel of fortune determined a random number. The
participants had to start their guessing by indicating if their estimation is higher or lower than the
number that was picked. Final estimations relatively close to the randomly assigned numbers, were
9
the result. A comparable result on the subject of valuation was more recently found by Ariely,
Loewenstein, & Prelec (2003); after filling in their zip codes, participants’ valuations of a box with
various products of daily use, differed significantly and were biased toward their zip codes. This
reveals the potential influence of a certain reference point on a choice with no demonstrable
affiliation. The reference points in the mentioned experiments were not set by the participants.
Though, valuations will also be biased toward deliberately determined reference points. This implies
a lack of adjustment to the current circumstances. If applied to the valuation of investment
opportunities, various valuations could serve as reference points. For example, earlier valuations
made by financial markets, competitors or external advisors. If these valuations are not sufficiently
adjusted to the difference in circumstances between the acquisition which functions as a peer and
the investment opportunity, misvaluation will be the result. A potential danger is the blindness for
the difference in economic value an investment target might have to different companies. For
example, an acquisition target could offer different synergy advantages to different potential
acquirers. Therefore, a valuation which is anchored on the perceived value of the target to a
competitor, might lead to misvaluation. In case the valuations which serve as reference points, are
incorrect itselves, another problem occurs. Due to possible inefficiencies in the financial market,
misvaluation troughtout the market might develop. If valuations of investment opportunitiess are
based on these misvaluations (possibly with the use of the multiples method) and no adjustments
are made, the valuations itselves will also be incorrect. Consequently, this could influence the M&A
activity. Some scholars argue that the mentioned misvaluation is the reason for the existence of
merger waves (Dong, Hirschleifer, Richardson, & Teoh, 2006), (Schleifer & Vishny, 2003) & (RhodesKropf & Visnwanathan, 2004).
An answer to the question how anchoring could lead to different valuations of the same target as a
consequence of economic circumstances, has to be formulated in order to consider if this might
confirm or contradict the conclusions which are based on the DCF method. Financial markets could
become ‘victims’ of bubbles during economic booms. Associated herding behaviour of competitors
and overoptimistic sentiments could consequently lead to overvaluation throughout the market.
Anchoring one’s valuation of an investment opportunity on these overvalued market values or prior
overpaid acquisitions by competitors, could result in overvaluation as well. Contrary, in a cold deal
market a discrepancy might occur between the target’s price to accept and the bidding price. The
target’s reservation price may be anchored on previous comparable acquisitions or market
valuations, whilst the bidder’s price is based on the circumstances in a cold deal market. Prices paid
in previous acquisitions and market valuations are in general lower during cold deal markets, than
during hot deal markets. This because of the fact that due to diminishing M&A activity during a cold
10
deal market, competition for investment opportunities and consequently prices also decline
compared to a hot deal market. If these prior acquisitions and valuations during a hot deal market
are the only used reference points for one’s valuation, then this results in the perception that bidding
prices are beneath the true value. Executives of potential targets may also anchor their valuation of a
potential upcoming divestment, on the target’s historical market valuations. If one assumes that a
relationship between business cycles and merger waves exists, then a cold deal market is
accompanied by an economic downturn. This economic downturn may have lowered the market
value of the target compared to a hot deal market during an economic boom. If the target’s
executives frame the deal on this prior higher market value, the earlier mentioned discrepancy could
be the result. The above is empirically tested by Baker, Pan, & Wurgler (2012). In their research, the
authors argue that prior stock price peaks are reference points for both the offer and acceptance
price. From the target’s prospective, the executives are reluctant to realize losses compared to the
reference point (disposition effect). The reference point is the stock price peak, whilst the perceived
loss is the difference between this peak and the divestment price. The bidding party may anchor
their bid also on a prior stock price peak, because the executives could think that the target has had a
certain value in the past, which should at least be matched in the future because of potential synergy
advantages. Besides, the bidders could anticipate on the loss aversion of the target’s executives, by
offering at least the stock price peak. The research finds evidence to conclude that the 52-week stock
price peak stronly affects the offer price made by the bidding party. As earlier stated, this could be
the result of the bidder’s anticipation of the target’s loss aversion.
Over-optimism/Overconfidence
The title used to indicate the bias considered in the this part, may give rise to some confusion. The
practical distinction between over-optimism and overconfidence could be small. However, Smit &
Moraitis (2010) state that over-optimism in the subject of valuation is expressed in the
overestimation of potential synergy advantages and growth potentials by executives, whilst
overconfidence refers to an executive’s overestimation of their abilities to seize these potential
synergy advantages and growth potentials. In other words, executives could be overconfident about
their abilities to seize growth opportunities, which in turn could also be overestimated by the same
executives. Camerer & Malmendier (2004) also make a clear distinction between over-optimism and
overconfidence. Over-optimism refers to one’s tendency to overestimate outcomes which are
related to exogenous variables, whilst overconfidence refers to the tendency to overestimate one’s
individual abilities and level of control. The cited scholars’ views could be combined, by posing that
over-optimism might result in an overestimation of growth and synergy possibilities, as a
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consequence of executives’ overoptimistic view about exogenous market conditions. Due to
overconfidence about one’s personal abilites and level of control, executives might get the
perception that they are (better than others) able to seize these growth and synergy possibilities.
Due to overconfidence, executives could also have the impression that there is no influence of
certain exogenous circumstances on outcomes which are relevant for the company of which they are
in charge.
Overconfidence has been subject to extensive scientific research. The findings are that
overconfidence manifests itself in many subjects and could have a significant effect, including: wars,
mergers and acquisitions, stock trading and labour strikes. However, the concept of overconfidence
has been tested in an inconsistent manner. In other words, different phenomena have been labelled
as overconfidence. Moore & Healy (2008) therefore proposed a classification into three different
concepts, based on the essence of the explored types and associated namings by scholars. This
classification will be followed in the remainder of this paper.
1) Overestimation. Overestimation is the tendency to overestimate ones personal abilities
concerning their level of control, performances and chances for success. This ‘kind’ of overconfidence
has been subject to most of the research done.
2) Overplacement. Overplacement refers to the perception about one’s abilities compared to others.
The term ‘better-than-average’ is also used in this context. The concept of overplacement could have
important implications for the subject of valuation. The executive with a substantial role in this
process and which can be prone to the bias of overplacement, is the CEO. A CEO could compare
himself to potential competitors for the acquisition of an investment opportunity and as a
consequence think that he is more able to seize the potentials of this investment opportunity. This
could result in a higher offer price. On the other, a CEO could also compare himself to other
employees in the company and may feel that he is more able to make decisions and should therefore
have the largest influence. This idea might be caused to the perception that his ability to make good
jugdment calls leads to his current position of CEO.
3) Overprecision. Overprecision means that people tend to be overconfident about their estimation
of the correctness of a decision/belief. A well-known way of experimentally testing this form of
overconfidence is to let participants answer a question, on which they subsequently have to make an
confidence interval about the correctness of their answer. The findings of various experiments was
that the given confidence intervals were too small. In other words, the participants are often to sure
about their estimation, see for example Klayman, Soll, Gonzalez-Vallejo, & Barlas (1999) & Soll &
Klayman (2004).
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The difference between the categorized concepts may seem irrelevant, but a combination of
overestimation and overplacement is paradoxical. Namely, research has shown that the personal
level of overconfidence can differ based on the difficulty of a performance or on the probability
something positive will occur. The more difficult a task of the more unlikely an event to happen, the
lower the degree of overconfidence; this is the so called hard-easy effect (Lichtenstein & Fisschoff,
1977). However, Moore & Healy (2008) has formed a model in which one’s perceptions about others
and the difficulty of a task are both included. In situations of a difficult task or unlikely event, people
underestimate their own performance or chances of success, which leads to underestimation,
although underestimating others’ performances or chances of success even more, which leads to
overplacement. This reasoning could influence valuations as well. If executives underestimate their
abilities or chances of success to seize certain opportunities an investment target offers, then this will
result in a lower valuation of such a target. However, if executives perceive the abilities or chances of
success of competitiors to be even smaller, then they could lower their bid consequently, since they
may expect their competitors’ valuations and biddings to be lower.
A bias closely related to overconfidence is the self-serving bias. Multipe phenomena are labeled
under this term. One of these, is the phenomenon that people tend to attribute successes to their
own actions and failures to exogeneous variables (Zuckerman, 1979) & (Bradley, 1978). The question
whether this tendency explains or amplifies overconfidence, will be answered in the next description
about which (other) factors are related to overconfidence.
The nature of the underlying causes of overconfidence could be psychological, see for example
(Griffin & Tversky, 1992), as well as neuroscientific. However, in order to justify the stated
hypotheses, the circumstances in which the factors which could affect the level of overconfidence
are present, should be examined. These factors could have the character of being conditions for the
existence of overconfidence, as well as being overconfidence amplifying. An example of the latter is
an executive’s tendency to attribute prior business successes to his management skills, which could
enhance the level of confidence for upcoming projects. Overconfidence concering outcomes (of
potential investments) which are partly dependent on the managerial skills of a CEO, could also be
amplified by the fact that executives have the tendency to think that they are able to have control of
the outcomes and chances of success. This reasoning could have the result that managers are
excessively optimistic about an investment’s future and are therefore willing to pay more. CEOs in
particular are sensitive to this tendency, since they might think that the position of CEO gives them
the most possibilities to control a certain process. Langer (1975) has demonstrated that one is not
always able to correctly assess the uncontrollable character of an event in which one’s own abilities
have barely any influence on the outcome. In the experiment which confirmed the above,
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participants who had been offered the possibility to pick an option of a gamble, were less willing to
sell their participation compared to the participants whose option has been assigned. Logically, the
chances of the chosen and assigned options were equal. This effect was reinforced when the
participants were offered the possibility to choose between a gamble of which the subject was
familiar to them and an unfamiliar subject. Again, the chances of both gambles were equally; fully
random. The composer of the experiment argued that the participants may reason in an analogical
way to events in which one’s abilities and skills increases the likelihood of success. For example, in
these events more involvement and familiarity to the task/event should increase the likelihood of
achieving the preferred outcome. In gambles of which the outcomes are strictly random, familiarity
and involvement have no effects. However, in the cited research was found that the perception
about competition, the familiarity to the context of the game, the possibility to choose the preferred
option and the participant’s involvement, are factors of which the participants thought that it could
alter the chances of success. This finding could be applied to the field of valuation as well; if
executives think that the operational activities of an investment target are related to activities with
which the executives are familiar, then these executives might have the illusion that they can control
the chances of the preferred outcomes. The underlying reason for the illusion of control could be
people’s aspiration to control their environment and their aversion to uncontrollability. Duhaime &
Schwenk (1985) proposed another reason, with both a cognitive and motivational character. When
analysing a task/event, decision-makers will first focus on aspects they can influence. If later asked to
make an estimation about the chances of success, decision-makers are less likely to think of other
aspects with they cannot control, since these aspects are less ‘available’ in their memory. This could
be seen in the light of the concept of availability (Tversky & Kahneman, 1974). Another potential
reason is the idea that decision-makers deliberately focus on other aspects of the event which they
can control, in order to limit the anxiety inherent to uncertainty. Gino, Sharek, & Moore (2011)
examined the illusion of control in settings of which the outcomes are largely dependent on
individual abilities. The findings of this research showed that in these circumstances the illusion of
control is weakened. However, it should be noted that the examined relationship is between the
perception of previous actions and results.
Overconfidence could also be amplified if new information confirms a certain hypothesis. In some
cases, the processing of this new information could be subject to a bias referred to as the
confirmation bias. This is the case if unjustifiable more effort is put into the evaluation of hypothesis
affirmative information than in the evaluation of hypothesis dissenting information (Jones & Sugden,
2001). A closely related concept is the self-attribution bias. According to DellaVigna (2009) there is no
substantial difference between the descriptions of the confirmation and self-attribution bias.
14
Confirmation bias is the tendency to perceive ambiguous new information as hypothesis affirmative,
whilst the self-attribution bias is the tendency to downgrade information that is contradictive to
one’s hypothesis. The self-attribution bias could be explained by the framework of Staw B. (1980).
According to this framework, there is prospective rationality and retrospective rationality.
Prospective rationality refers to the situation in which (in this case) executives search for and process
information so the future decisions are payoff maximizing, whilst retrospective rationality refers to
the situation in which executives try to rationalize decisions which are already made. One way to
rationalize such an earlier decision is to attribute failures to external circumstances. The latter is
often used to defend prior decisions. Therefore, executives might have the tendency to defend their
decision if outcomes turn out to be unfavorable. Attribution of positive outcomes to one’s own
behavior could serve as an amplification of self-esteem, which is the opposite to the argument of
defending one’s choice and position. The above is, among others, is tested by Bettman & Weitz
(1983). By analazing annual reports and coding the described information as a favorable or
unfavorable outcome, as wel as the mentioned cause of these outcomes, the scholars could conclude
that executives indeed attribute positve outcomes to internal causes and unfavorable outcomes to
external causes. However, it is unclear if the found conclusion could be completely supported by
Staw’s ideas about prospective and retrospective rationality.
Another interesting phenomenon which could explain the aforementioned hypotheses (I & II) was
found in an experiment by Langer & Roth (1975) and is a combination of the illusion of control and
the self-attribution bias. In this experiment participants had to guess the outcome of a coin flip.
However, the outcome of the toss was predetermined by the scholars. One group of participants
were told that they were right most of the time in the first half of 30 tosses, hereafter they were
‘wrong’ most of the time. Another group was confronted with the opposite sequence of outcomes.
The outcomes of the guesses made by participants of a third group were randomly determined. After
the toss, the participants had to fill in a questionnaire concerning the degree of control. Curiously,
the participants of the first group claimed that they had more control than they other groups. The
researches argued that the participants in the first group might have perceived the task as skill
related after some correct choices. In addition, the participants may undervalue outcomes that
contradict their hypothesis (self-attribution). The above was confirmed in another experiment, which
in addition concluded that the participants which were confronted with succes in the beginning,
thought that they could still anticipate the coin flip in the next 100 tosses (Burger, 1986). This is
despite the fact that these participants were encountered with incorrect outcomes in the second
part of the tosses. In other words, due to the sequence of outcomes, the participants became
15
overconfident about their abilities.The application of this phenomenon to the valuation of acquisition
targets, will be discussed in the sequel of this paper.
Another reason which may enhance overconfidence is commitment to certain outcomes (Weinstein,
1980). In the subject of M&A, the outcome of an acquisition or merger could have a major impact on
an executive’s financial compensation, since a share of the financial compensation is a combination
of shares and options. The author argues that this is due to people’s erroneous thought that others
barely try to alter their behaviour in order to achieve preferable outcomes.
Camerer & Malmendier (2004) applie the findings by Alicke, Klotz, Breitenbecher et al (1995), that
the level of overconfidence is higher when a point of reference is abstract and not individual, into a
managerial context. When CEOs are analysing an investment opportunity, they have to take the
alternatives into account. If this alternative is an investment in financial securities adjusted for the
risk, then this could lead to overconfidence, since a CEO could perceive this as being abstract.
The application of overconfidence on a managerial setting has been thus far shortly described. An
empirical test whether overconfidence leads to certain perceptions about one’s managerial skills has
been conducted by Larwood & Whittaker (1977). In this article students and managers were the
subjects in an experiment about overestimation concerning business success and actions. Both the
students and managers stated that they thought that they outmatched the other participants on
subjects as IQ and perseverance, as well as managerial skills. These thoughts result in overoptimistic
expectations about a company’s future. The experiment is related to another well-known experiment
by Svenson (1981) in which an overwhelming majority of the participants stated that they are better
drivers than average. This phenomenon is confirmed by means of an experiment in which 37% of the
respondents stated that their working capacities were in the top 5% of the company (Zenger, 1992).
Entrepreneurs of start-ups are overoptimistic about the chances of success (Cooper, Woo, &
Dunkelberg, 1988). Small financial reserves and the absence of a critical view on the strategy could
be problems related to this over-optimism. The entrepreneurs’ estimations of chances of success for
others, was lower than their own predicted chances. The the degree over-optimism was higher after
the company was started.
Roll (1986) was the first scholar who argued that M&As could be the consequences of what he called
hubris (which is in line with the term overconfidence). At that moment, the scientific idea existed
that acquisitions occurred as a result of potential synergy advantages, tax benefits and/or
mismanagement. Roll stated that if the assumptions of a strong-form efficient market and hubris are
made, the market value of the potential acquirer should decrease, opposed to the market of the
target. He did not find significant prove for this, but the idea of a relationship between
16
overconfidence and M&A activity was proposed. Hayward & Hambrick (1997) found an indication for
the relationship between indicators of overconfidence and premiums paid in acquisitions. These
indicators are historical business performance, CEO related media news and the perceived status
compared to other employees. Media news could amplify a CEO’s overconfidence, since a CEO could
adopt the outside view of the media. The proxy for an executive’s perception about his position is
the ratio between the CEO’s financial compensation and the second executive’s compensation. If the
difference in compensation is high, the CEO could have the perception that the company’s (board of
directors) view is that he is the person who has made the best decisions. Malmendier & Tate (2005)
has examined the relationship between overconfidence and valuation/bidding as well. In their
research the found evidence for the conclusion that overconfidence could result to overinvestment
or –pricing, if internal cash reserves are sufficient. The latter is based on the idea that financial
markets could bound the executive’s aspiration to invest, if there is insufficient cash and
consequently external financing is necessary. Executives might be unwilling to finance externally,
since they have the view that the company is undervaluated by the financial markets. This possible
point of view is based on the fact that such executives overestimate the value of the company, as this
value represents the value of future investments as well, which are overvalued by the executives due
to overconfidence (and over-optimism). The way the Malmendier & Tate have measured the degree
of overconfidence could be of value to further research which makes use of data from a database.
Because of the form of financial compensation by means of shares and options combined with the
restriction to hedge the accompanied risk, risk averse executives should exercise their given options.
The authors determined the moment at which ,given the executives risk profile, he should exercise
the options. If this moment was exceeded, one can conclude that these executives are overconfident
about their abilities and the performances of the company. This is later confirmed in another
research (Malmendier & Tate, 2008).
Empirical findings concerning the effect of overconfidence on valuations made by executives have
been considered. However, this is not sufficient to justify hypothesis I & II; the relationship between
the temperature of the M&A market and valuations made by executives. The link between prior
business experiences (related to temperature of M&A market) and overconfidence has to be made,
which will be done in the next section.
Relation temperature of the market and overconfidence
In order to justify hypothesis I and especially hypothesis II, the relationship between the temperature
of the M&A market and the level of overconfidence has to be considered. Combined with the earlier
described correlation between the level of overconfidence and prices paid for investment
17
opportunities, the effect of the relation between the temperature of the M&A market and valuation
can be derived.
Recall that the assumption is made that the condition of the M&A market is related to the business
cycle and therefore as well as to company performances. A company in a hot deal market is
therefore assumed to have encountered a positive business experience, whilst a company in a cold
deal market is assumed to have encountered prior negative businesses experiences. Unquestionably,
firm-specific variables could offset the influence of the business cycle and therefore undermine the
assumption. However, one may expect that the correlation holds in general.
Experimental findings suggest that executives, who had been confronted with an earlier loss, were
less optimistic about their company’s future compared to others (Larwood & Whittaker, 1977).
However, it is ambiguous whether this perception is based on the idea that exogenous circumstances
will be negative or on the idea that they executives are less confident about their own managerial
skills.
In case of positive prior business experiences, the level of overconfidence could also be enhanced.
There are various factors which could alter one’s overconfidence, including: the illusion of control,
the confirmation bias, the self-attribution bias, commitment and abstract reference points. One of
these factors could be the reason for the positive relationship between prior business experiences
and the level of overconfidence. As earlier stated, an executive could have the perception that the
position of CEO offers the greatest opportunity to have control over decisions to be made. In order to
become CEO, it is expected that one has had multiple successes. Therefore a positive relationship
might exist between prior successes and overconfidence. However, the hypotheses in this paper are
based on a situation of prior business experience encountered in the role of executive, not of the
period before. On the contrary, the bias of self-attribution could be a plausible explanation. If prior
business success is attributed to the actions made by an executive, this could reinforces an
executives’ self confidence and consequently lead to overconfidence. On the other hand, the selfattribution bias implies that executives have the tendency to attribute prior negative business
experiences to exogenous circumstances. Due to this tendency the self esteem of executives could
be asymmetrical altered compared to the situation of prior business successes. In other words: prior
positive business experiences enhance the level of confidence more than prior negative business
experiences decreases the level of confidence. This effect might possibly be reinforced by
groupthink. Another explanation for the relationship between prior business experience and the
level of overconfidence is the so called reactance effect (Wortman, Brehm, & Berkowitz, 1975). This
refers to the idea that after an initial setback, one could be extra motivated to act rationally in their
18
next decision by, for example, taking more conditions into account. It is ambiguous whether this
effect results in higher or lower valuations. If prior business experiences have resulted in a certain
degree of mental depression, then this could lead to a more realism. This phenomenon is called
depressive realism (Alloy & Abramson, 1979). However, given the lack of scientific appliance to a
managerial context, this potential reason is left aside. Besides the fact that according to some
theories, emotions could be the underlying factors of the described biases, the assumption of
depression would be too speculative
Summarized, multiple factors could have an influence on the level of overconfidence. However the
relationship between prior business experiences and overconfidence is most plausibly explained by
the self-attribution bias. When comparing the level of overconfidence between participants which
are given a positive business history to participants without a given history, a difference should occur
(hypothesis II). This could be substantiating by the idea that past successes can be attributed to one’s
own actions. If no history is given, one could be prone to overconfidence as well, but the level of
overconfidence has not been enhanced by prior experiences.
Loss Aversion
Loss aversion refers to the phenomenon that people weigh losses relatively heavier than they weigh
gains (Kahneman & Tversky, Prospect theory: an analysis of decision under risk, 1979). In an
experiment by these authors, they found that participants are unwilling to accept a gamble with
equal chances for equally sized gains and losses, which indicates an aversion towards losses. For
example, most of the participants would reject a gamble in the form of (100, 0.5; -100, 0.5). This also
occurred when the size of the potential gains exceeded the size of the potential losses to a certain
amount. The latter contradicts the expectations derived from the normative expected utility
function, since according to this theory people make no distinction in the utility derived from gains
and losses. Kahneman and Tversky (1979) have therefore proposed a new descriptive theory, which
does provide an explanation for loss aversion: prospect theory. The characteristics of this theory
which are important for the composition of the experiment will be shortly treated in this section. For
an in-depth explanation of prospect theory, one should look upon the original papers: Tversky &
Kahneman (1992); Kahneman & Tversky (1979). Moreover, the nature of the experiments described
above provides one the opportunity to measure the degree of loss aversion by determining the ratio
between possible gains and losses of a gamble of which participants are indifferent to participate. In
other words: how many ‘units of gains’ are needed to compensate for ‘one unit of loss’? Tversky &
Kahneman (1992) found that in their sample, this ratio was around 2.25. However, there is no
19
universally agreed measure for loss aversion, as well as an universally agreed ratio (Wilkinson &
Klaes, 2012) .
One of the most important aspects of prospect theory is the shape of the utitility function. The shape
in the area for positive results is concave. In contrast, the shape of the utility function in the area of
negative results is convex. Furthermore, the utility function is kinked at the origin. The origin
represents a certain reference point, to which the outcomes are evaluated as gains or losses.
Moreover, in the area for losses the curvature of the utility function is steeper than in the area for
gains. This is indicative for loss aversion.
Loss aversion may lead to risk averse behaviour; although the chances and size of potential positive
outcomes are larger, as soon as the decision at hand includes negative outcomes, one could refrain
himself of entering into risky events (Kahneman & Lovallo, 1993). One may assume that loss aversion
and the relationship with risk aversion are also applicable in the subject of managerial decisionmaking. However, the level of loss aversion could be higher in a managerial context due to
asymmetric accountability for losses and gains (Kahneman & Lovallo, 1993); (Tetlock & Boettger,
1992). Consequently, executives’ actions could be conflicting to a company’s best interests, as a
result of executives’ potential perceptions that future failure will be evaluated in a different way than
future gains. In other words, an executive could be more risk averse than wished.
Relationship temperature of the market and loss aversion
In order to be able to justify the hypotheses I & III, it is important to identify how loss aversion could
influence executives’ valuations and how it is related to prior business experiences. The difference
between executives who are framed in a cold deal market, compared to executives who have been
framed in a hot deal market, or not have been framed at all, is the difference in their given prior
business experiences. Therefore, if one expects that executives’ valuations differ as a result of prior
business experiences, the latter should be related to loss aversion as well. More generally stated, the
concept of loss aversion provides an explanation for the relationship between valuation and business
experience, if prior business experience is related to the concept of loss aversion and loss aversion is
related to the concept of valuation through risk attitude. There are two conflicting views about how
prior business experience (positive/negative) could alter executives’ risk attitude, namely the
escalation of commitment and house money effect (Weber & H.Zuchel, 2005). Both interpretations
are based on the concept of loss aversion. Therefore, this is the manner in which loss aversion
manifests itself as an influencing factor on valuations in a hot and cold deal market.
20
If an executive is confronted with negative feedback about a prior decision/investment, he may value
a new opportunity which could demonstrate that he is able of making good decisions (Staw B. M.,
1981). This opportunity could be an investment which is unrelated to the prior one. However, if the
prior decision was part of a strategy, the executive could have the tendency to rationalize his prior
decision (retrospectively) by proceeding with the next planned steps of the strategy. This could result
to an overvaluation of the new investment opportunity, since it has ‘extra’ value to the executive,
namely the option to rationalize his earlier decision and to continue with the strategy. This tendency
could lead to escalation of commitment. The term commitment implies that the prior and the new
decisions are related by means of a strategy, and the nature of the bias is therefore more specific
than the idea that any new investment opportunity should be valued higher (Weber & Zuchel, 2005).
The underlying cause of escalation of commitment could be explained by prospect theory: executives
who are confronted with negative feedback consider themselves in a loss position compared to their
reference point. Since people have an aversion to certain losses, the new decision provides them the
opportunity to have such a positive outcomes that it offsets the perceived loss. However, the
executive has to perceive the new decision as part of the same strategy as the prior decision,
otherwise the reference point shifts (Weber & H.Zuchel, 2005). Escalation of commitment has been
further elaborated in scientific literature, see for example (Bazerman, 1984) & (Whyte, 1986).
Bateman & Zeithaml (1989) have conducted an experiment with both students and executives which
confirmed escalation of commitment. After the participants had been confronted with initial failures,
an new investment opportunity was presented. When this new investment oppurtinity was postively
framed, then the above resulted in a increase of investmens. In case the follow-on investment
opportunities were negatively framed, it resulted in a decrease of investments. MacCrimmon &
Wehrung (1986) has shown in their research that executives state that an earlier success or failures
affects their risk attitude, which results in the decision whether to invest and at what price. If
executives have the perception that competition for a new investment target exists, combined with
the thought that this investment is necessary, then this will result in higher biddings. The interviewed
executives stated in line with the above, that after a negative business experience, executives have
to accept more risk in order to eventually reach their target. On the other hand, executives’s
perception of the concept of risk is mainly determined by the size of the negative outcomes, instead
of the uncertainty related to a certain decisions (March & Shapira, 1987). After suffering a prior loss,
another loss could have large consequences for the company’s continuity. This scenario could lead to
reticence concerning investments. The above summarized: a negative business experience could lead
to escalation of commitment, which in turn could lead to higher valuations. Two important
assumptions have to be made. Firstly, there is a relationship between prior business experience and
21
the temperature of the M&A market. Secondly, the new investment is related to prior investments,
for example by means of a strategy.
The term ‘house money effect’ has been introduced by (Thaler & Johnson, 1990) and refers to the
phenomenon that people are more risk seeking after having experienced a prior gain. This could be
explained by one’s perception that the gained money is not part of one’s wealth yet and therefore
makes a decision with the idea that the money belongs to someone else. This is related to the
concept of mental accounting. Empirical evidence has also found that the inverse is true, namely that
prior losses incur risk adverse behaviour. This last observation however only holds if the decision
after the loss, does not provide the opportunity to break-even with respect to one’s initial reference
point. The empirical evidence for the house money effect may be less convincing as the evidence for
escalation of commitment, however this might also be attributable to restrictions inherent to the
experiments used to prove both the effects. In other words, due to limited personal stakes for
subjects in the experiments, the validity of the evidence over decision with higher stakes, is
questionable. The relationship between prior business experiences and valuations can be explained
by the house money effect in the following way: a negative prior business experience could lead to a
more risk averse attitude, which in turn could lead to no or lower biddings of investment
opportunities.
It should be clear that the escalation of commitment and the house money effect have a conflicting
character. Both concepts alter one’s risk attitude, however this is dependent on different prior
business experiences. Testing hypothesis III provides one the opportunity to see which concepts
influences the valuations. The share of the participants will be confronted with a negative business
experience which has an ambiguous cause, whilst the other participants will not have such an
experience. If the valuations made by ‘framed’ participants are higher, then this will indicate the
escalation of commitment. If the opposite is found, then this gives an indication for the house money
effect.
Narrow framing
Narrow framing is the phenomenon in which people evaluate decisions under uncertainty in isolation
of all other risks a person is already facing (Barberis & Huang, 2008). Posed differently by Kahneman
& Lovallo (1993); ‘narrow framing is people’s tendency to consider problems in isolation of other
choices, or future opportunities of making the same decisions’. Narrow framing is an example of the
so called framing effect. Framing is the phenomenon where the manner of presentation of a choice
22
alters one’s decision, which is in violation of the rational choice theory assumption of invariance
(Tversky & Kahneman, 1981).
Narrow framing has been subject of much research. Tversky & Kahneman (1981) have conducted an
experiment in which participants had to make two choices. Before making this choices they could
evaluate all the options. Choice 1 concerns the choice between a sure gain of 240 (A) or a gamble
consisting of a 25% chance to gain 1000, and a 75% chance to gain nothing (B). Choice 2 concerns the
choice between a sure loss of 750 (C) or a gamble consisting of a 75% chance to lose 1000, and a 25%
chance to lose nothing (D). They are first explicitely asked to examine both choices before making the
two decisions. The espected payoff maximizing combination of options would be to choose B & C,
since the combined gamble would be: 25% chance to win 250 and 75% chance to lose 750. However,
an overwhelming majority opted for the combination of options A and D. This result could be
explained by the tendency by the participants to evaluate each outcome in isolation. The choice for
option A should be seen in the light of risk aversion, whilst participants’ decisions to choose option D,
could be explained by loss aversion and consequently risk seeking behaviour in the area of losses.
Summarized, narrow framing is one’s tendency to focus on the outcome of a single choice without
properly accounting for other risks.
Another empirically tested maninfestion of narrow framing could be of value to the subject of
valuation. In an experiment by Samuelson (1963), participants stated that they are unwilling to
accept a gamble with equal chances to win 200 or lose 100. The same participants were willing to
accept the gamble if they were initially informed that they would be offered the same gamble
multiple times. The author posed the question if one should accept a gamble of which he can almost
be sure that other gambles will follow, in case one accept a gamble of which he is certain that other
will follow. This can be translated to the topic of valuations as well, since an executive might value an
investment opportunity in isolation of future investments. Certain investment opportunities
themselves embed the option of a future choice with uncertain outcomes. If such options are
neglected, the valuation is unjustifiable low. Therefore the objective method of real options could be
a solution.
One of the proposed underlying causes of narrow framing is people’s way of processing information.
For his reasoning Kahneman (2003) used the two-system view (Stanovich & West, 2000), which
refers to the distintion between intuiton and reasoning. In the light of this view, people use two
types of cognitive processes. One way of processing information (intuition) is characterized by terms
as: automatic, implicitity, fast, driven by habits and difficult to alter. The other way of processing
(reasoning) is characterized by opposite terms as slower and more controllable. During the valuation
23
process, the decisions made by executives are often based on certain intuitive judgement calls, which
could lead to narrow framing. As earlier mentioned, this way of processing is difficult to alter.
However, reasoning could (partly) offset the effects of intuitive thinking. Reasoning is more prone to
certain rules and formats. If executives make use of some kind of predetermined format or rules,
which leads them to see an investment opportunity in combination with other risk and opportunities,
then this could counteractive to narrow framing. One of these predetermined formats or methods
could be the implementation of real options into the valuaton process.
Summary – Hypothetical relation between market temperature and valuations
Various cognitive biases and their translation into a managerial context have been described, as well
as their relationship to both prior business experiences and valuations. However, since these biases
could have opposite effects and causalities, it is hardly possible to give an indication which biases are
involved in the valuation process. In this section the relationships which are proposed in order to
justify the hypotheses are summarized and combined.
Hypothesis I states that participants who were given a history of prior business success, value a
certain investment opportunity higher than participants who were given a history of prior business
failure. Translated into a managerial context, this hypothesis implies a relationship between prior
business experience and valuations because of executives’ receptivity for cognitive biases. However,
the described biases of overconfident, loss aversion and narrow framing could all be related to both
positive and negative prior business experiences and could therefore be mutually reinforcing or
mitigating. In order to test whether real options could provide a solution to these biases in valuation,
it is required to have knowledge about which biases are involved. The use of real options could
prevent making these biases or countervail their effect on valuations. Therefore the experiment will
be based on hypotheses II & III as well. Testing these hypotheses will provide one the possibility to
see whether and which biases are involved. A justification of these hypotheses will be summarized
and graphically shown.
24
Overconfidence (positive business experience/hot deal market)
As earlier described a positive business experience could lead to a higher level of overconfidence,
which in turn could lead to a higher valuation. Therefore relationship ‘2’ and ‘4’ are positive. The
opposite may hold as well: a negative business experience could lead to a lower level of
overconfidence, which in turn could lead to a lower valuation. However, executives can be prone to
overconfidence without a prior experience as well, since overconfidence is a natural tendency and
related to the concept of the self-serving bias. Therefore, valuations made by participants with and
without a given business experience during their period in the role of CEO, could be both subject to
overconfidence. However, the self-attribution bias is a cause or amplifying factor of overconfidence
and only applicable in a situation in which prior ambiguous information could be evaluated. Hence,
one could expect that the valuations made by participants who are framed in a setting of prior
business success, are higher than valuations made by participants without a given prior business
experience. This is because of the following reasoning: prior business successes will be attributed to
one’s own actions, which enhances the level of overconfidence, which in turn leads to a higher
valuation. However, feedback is necessary in order to attribute certain aspects of a success to one’s
own actions. This feedback will not be given to a group of participants and consequently, their level
of overconfidence cannot be altered by the self-attribution bias. If the findings of the experiment
illustrate that no difference in valuations exists, then one could argue that there is no relationship
between prior business experience and the level of overconfidence or that the experiment does not
offer enough information for the participants to be able to attribute successes to themselves
(hypothesis II). The latter possibility could also be the result of the experiment’s inability to create a
perception of groupthink and outside evaluation. If an executive has experienced successes, then this
could lead to positive outsiders view (board of directors, media etc.), which in turn could enhance his
level of overconfidence.
25
In case of a negative prior business success, executives could still be prone to overconfidence. An a
contrario reasoning opposed to the previous described relationship, implies that a negative prior
business experience will decrease the level of overconfidence. This prior negative business
experience, though, will partly be attributed to exogenous circumstances, which will result in a
smaller decrease of the level of overconfidence, than a positive experience enhances this level. Other
potential explanations that have been earlier described, are related to the concept of loss aversion.
Loss aversion is due to risk perception, whilst overconfidence is due to the estimation of risk (Smit &
Moraitis, Playing at serial acquisitions, 2010). These concepts are therefore in a different way related
to valuations. Loss aversion refers to one’s risk attitude and could lead to a status quo situation or
reticence in a managerial context. Whilst, overconfidence refers to one’s estimation of chances and
outcomes and could therefore alter the valuation in a managerial context. Loss aversion could be
related to prior experiences and investment decisions in different ways, namely the earlier described
house money effect and the escalation of commitment bias. The house money effect refers to the
situation in which prior business experiences affect the risk attitude, which in turn affects investment
decisions. One might say that escalation of commitment is related to valuation in a more indirect
way. Prior business experiences may lead to the mental perception that one has the position of a
certain loss. The loss aversion to this certain loss, may result in the willingness to accept more risk in
a next decision. If this next decision is an investment opportunity, then this might lead to a higher
individual valuation, since it offers the opportunity to offset the certain loss or demonstrate one’s
abilities. The relationship described above, could be graphically shown.
House money effect (negative business experience/cold deal market)
A negative
prior business experience will result in more risk aversion, therefore a positive
relationship (2) exists between ‘1’ and ‘3’. More risk averse/less risk seeking behaviour will
(indirectly) result in lower valuations and bids, which implies a positive relationship between ‘3’ and
26
‘4’. Consequently, if the house money effect is involved in a managerial setting, the expected
relationship between prior business experiences and valuations is positive.
Escalation of commitment (negative business experience/cold deal market)
According to the escalation of commitment bias, a negative prior business experience will result in
the perception that one’s current position is a loss compared to a reference point. This perception
will lead to more risk seeking behaviour if an investment opportunity related to the prior business
experience, is offered. Therefore a negative relationship between ‘1’ and ‘3’ should exist. The
relationship between ‘3’ and ‘4’ is supposed to be same as with the house money effect. The above
results in the assumption that according to the escalation of commitment bias prior business
experiences are negatively correlated to valuations.
By testing hypothesis III, it is possible to see whether the house money effect or escalation of
commitment has a stronger effect on the valuation process. A lower valuation by the participants
who are given a negative prior business history gives an indication for the house money effects.
Whilst a higher valuation compared to the participants who are not given a business history gives an
indication for the escalation of commitment.
In case hypothesis I is confirmed, it is difficult to make conclusions about the question which biases
are the cause of the difference in valuations, and to what extent. However, testing hypotheses II & III
gives the opportunity to gather information about the involvement of certain biases, albeit in a single
scenario (hot or cold deal market).
27
Real options as a solution for static DCF valuations
If the question which psychological biases affect valuations and M&A activity, is answered, then one
could pose the question: how to ‘debias’ valuations? The easiest way would be to make executives
aware of their biases. However, this awareness barely results in decisions which are less biased. An
explanation is offered by Kahneman, Lovallo, & Sibony (2011). They refer to the earlier described
distinction in the way of thinking: System one and System two. System one is the way of thinking
which is more intuitive and effortlessly. This way of thinking enables people to talk, read or sport:
people do not have to think about the question how to do something. System two is more effortful
and conscious. People use both systems, however system one is used most of the time, unless a
decision’s interests are high or rule-based. The use of system one is mostly positive, since it helps
forming a context instantly. However, it is almost impossible to be aware of an error at the moment
people are making him intuitively. Therefore it is hard to find a solution for such an error, if one is
unaware of the fact that he is making an error at that time.
In the subject of M&As, Garbuio, Lovallo, & Horn (2010) introduced the idea of targeted debiasing.
This way of debiasing is based on a breaking-down of the decion-making process into different stages
and a subsequent identification of the biases which are related to these different phases. As a
solution to the problem of overconfidence, the authors refer to (Kahneman & Lovallo, 1993), who
proposed the idea of using reference-class forecasting. The term itself helps explaining the concept.
An executive has to form a group of comparable past investments and range the accompanied
outcomes. This should help the executive to consider all the possible outcomes of the investment
opportunity, instead of scenario-thinking about the investment opportunity. The executives could
also range the past synergy advantages. In this way reference-class forecasting could be valuable to
over optimism about external circumstances as well. Loss aversion and narrow framing are also part
of the targeted-debiasing method. The authors recommend that executives perceive a risky
investment opportunity in combination with other strategies choices. However, this could be difficult
from an executive’s point of view, since an executive may be kept responsible for the outcomes of an
individual decision.
Smit & Moraitis (2010) proposed the use of real options as a solution for the influence of cognitive
biases on the valuation process. The characteristics of the use of real options as a valation method
have on certain points the same meaning as the solutions described above. These solutions focus on
undoing and preventing biases. Real options could also be used in order to be countereffective to the
28
influences of biases on valuations. For example, loss aversion combined with a valuation based on
the DCF method could lead to the decision to forego on an investment opportunity, since the DCF
leads to the idea of a Go/No-go decision. However an option to stage an investment should also be
considered in such situations, since this staging gives the opportunity to wait or abandon the
investment. In order to see, how real options could be a valuable addition to the DCF method, the
problems with the DCF and characteristics of certain real options has to be considered.
The DCF method has a static nature, since it does not embed the possibility of waiting and making
follow-on decisions (Smit & Moraitis, Playing at serial acquisitions, 2010). The conclusion of a DCF
analysis is invest or not invest: if the net present value of future cash flows is greater than zero, one
needs to invest, opposed to the situation in which the NPV is less than zero. However, it is possible
that the NPV of an investment opportunity is negative, but the best strategy is to invest nevertheless.
This could be the result of the possibility of a follow-on investment if a prior investment is made. The
value of this opportunity could offset the negative stand alone value of the first investment
possibility. On the other hand, it is also possible that the NPV is positive, but the best strategy will be
to wait, since the circumstances could differ.
Besides aforementioned shortcomings of the DCF method and the added value of the use of real
options, the implementation of real options requires decision-makers to take certain variables into
account which could be neglected or subjectively perceived due to cognitive biases.
After a strategy has been determined, a process in which executives have a leading role, an executive
could have the illusion that he has control over the entire process of the strategy and therefore could
continue making acquisitions, although circumstances might have changed (Smit & Moraitis, Playing
at serial acquisitions, 2010). The use of real options requires an executive to take exogeneous
circumstances into account and to beware of the possibilitie that potential follow-on investments are
also subject to uncertainty. Real options could consequently have a preventive effect on the illusion
of control bias. This effect could also prevent self-attribution, since executives need to estimate the
influence of exogenous variables on the outcomes of an investment opportunity. Therefore, it is
harder for an executive (and his team) to attribute positive results to their actions. The oppositie also
holds: in case of negative outcomes, executives’ tendency to rationalize decisions retrospectively,
could be reduced. Real options could reduce the effect of narrow framing on valuations as well.
Narrow framing could lead to seeing a decision in isolation of other risks and future decisions of the
same kind. Executives are enforced to look for growth/expand options which are provided by making
an initial investment. The potential follow-on investments also embed risk, with which the risk of the
initial investment could be combined. Smit & Moraitis (2010) state that the use of real options could
29
be the solution for problems related to overcommitment as well. If executives might have the
perception that they are in the position of a loss compared to a certain reference point, they might
continue to make investments in order to seize the opportunity to reach a position of gain. This
effect could be amplified if an executive have the perception that he is been taken responsible for
failures. The use of real options provides an executive a predetermined target of which the chance of
reaching it is subject to uncertainty, which therefore offers him the opportunity to limit his perceived
accountability.
In order to make use of the described advantages of real options, executives should be able to see
the conditions in which real options are existing. In other words, executives should be able to
recognize the characteristics which make certain opportunities valuable. The experiment will test this
reciptivity for different real options. The choice for this real options and the setting (hot or cold deal
market) in which they are examined, are based on a checklist proposed by Smit & Lovallo (2014). This
checklist should help executives to have a countereffect on their potential biases. Since the existence
of these biases and their effect on valuations could vary for different conditions of the M&A market
(which is assumed to be related to the business cycle), awareness for different kind of real options is
required as well. In situations of a cold deal market, which is related to prior negative business
experiences, executives should be encouraged to seek for options to grow/expand or abandon. In
situations of a hold deal market, executives should be cautioned and therefore encouraged to search
for opportunities to stage or wait. In the experiment will be tested if the participants are able to
recognize the characteristics of an option to stage/defer in a hot deal market and option to
expand/grow in a cold deal market. The experiment will also be used to test whether participants are
able to recognize the value of the possibility to exercise an option at multiple times, compared to a
one time opportunity. This could be expected, since an option which is exerciseable at multiple
moments could be converted into an option which is exerciseable at one moment. The first kind of
option is therefore dominant to the second kind.
Hypothesis IV
Participants are able to recognize and value the characteristics which add value to real options.
The recognition of value adding characteristics to real options should lead to higher valuation if the
introduction of a such a characteristics is the only aspects that changes in a setting. As earlier stated,
the real options which are implicitly added in a context are the option to stage or defer and
grow/expand.
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Real options
An option to defer is characterized by the possibility to ‘wait-and-see’ (a term which could be
applicable to all real options, however, ‘wait’ refers in this case refers to waiting to invest). As earlier
stated, an analysis based on the DCF method could lead to the conclusion to invest, because the NPV
of the estimated cash flows is positive. However, if one waits in order to see if the market conditions
turn out to be more positive for the investment opportunity, then this could be a better strategy. The
possibility to be able to wait is valuable. The valuation of this option could be derived from the
method of option pricing in financial markets. In this light, the option to defer could be seen as a call
option with the investment outlay as exercise price and the NPV of the cash flows generated during
the lifetime of the investment, as underlying value. However, deferring an investment could have a
disadvantage, since possible positive cash flows could be forgone. Options to defer are especially
valuable in cases where there is some kind of constraint for competitors, because in the period in
which investment is deferred, competitors could not alter an investment’s future profitability. After
an investment has been made, one often has the opportunity to sell this project/patent/division/etc.
at various moments. This opportunity could be valuable in the event that at a certain moment the
NPV of the future cash flows is lower than the potential selling price. The value of this opportunity
can be determined by calculating the value of a put option with future cash flows as the underlying
value and the potential selling price as the exercise price. Another important real option is the
growth option. This term is differently used by scholars. However, in this experiment a growth option
is, simply stated: the possibility to decide whether to make another decision, as a result of a decision
that has been earlier made. In other words, by making an initial investment, the possibility of making
following decisions is created. This opportunity could be valued as a call option, with the NPV of
future cash flows as the underlying value and the required investment outlay for the follow-on
investment as the exercise price. This valuation process could become complicated when the followon investment itself creates the opportunity for further investments. A combination of real options
could be applicable to certain investment settings as well. An example is the option to stage an
investment, which could be seen as an option to defer and an option to abandon. Recall that Smit &
Lovallo (2014) state that real options could be used to offset the effect of certain cognitive biases on
valuations. Since the effect of cognitive biases on valuations is dependent on the condition of the
M&A market, different real options should be used in these different conditions. The authors
proposed to make executives aware of options to defer (cautionary) in hot deal markets, and to
make executives aware of options to grow and to abandon in cold deal markets. Therefore the
31
option to stage investment could be applicable to both situations and will be tested in the
experiment as well.
The hypotheses and their potential explanations described in this section are the subject of the
conducted experiment. In the next section a justification for the steps taken in the experiment will be
given, in order to demonstrate how the concepts described in this section could be translated into an
experimental setting.
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Experiment
The composed experiment can be found in Appendix A. The headers used in this section correspond to
the headers used in the experiment. One should read the paragraphs below in conjunction with the
corresponding parts of the experiment.
Operationalisation of hypotheses
The composed experiment aims to test the two expectations, formed in the section above. Firstly,
whether a difference occurs between participants’ valuations after being framed in a hot or cold deal
market. Secondly, if the participants’ valuations give indication that they are receptive for the
existence of certain real options in a managerial setting. If the latter is confirmed, this provides
credibility to the statement that real options could alter potential biased valuations made by
executives, as stated by Smit & Lovallo (2014). In order to test these expectations a sample is divided
into four groups of equal size. In the remainder of this section, these groups will be referred to as I, II,
III and IV. The treatment of each of the groups is different. Group II and IV will serve as some kind of
control group to respectively group I and III. Group I and III will be manipulated into respectively a
hot and cold deal market, which are related to a positive and negative prior business experience.
Following the reasoning in the theoretical framework, the valuations of these framed groups I and III
should differ. The average valuations of group I and II should also be different, since only group I is a
positive past business experience. The opposite should hold for the group III and IV, although given
the ambiguity regarding the aforementioned literature on the effect of prior losses on current
behaviour, this expectation could turn out differently. Since group II and IV are control groups and
receive the same treatment (no prior performance results), their initial valuations should not
significantly differ. However, after the initial valuations, the control groups are given different
questions, in order to match the questions of the groups they serve as control groups for, this should
lead to different outcomes. Testing the expectation regarding the receptivity to real options, should
lead to relatively higher valuations for all groups. If this is not the case, this could be an indication of
the far-reaching influence of biases which were also present at the initial valuation, or an indication
that participants are not able to recognize important characteristics of real options in a real life
setting.
Participants
The research question relates to valuations made by executives. However, the participants in the
experiment are students. One could therefore pose the question whether the findings of the
experiment have external validity. It could be expected that executives are more capable of making
better/rational decisions than others, since the ability of making rational choices is a requirement for
33
obtaining the role of executive (Larwood & Whittaker, 1977). However, it is questionable as well,
whether this statement implies that executives are less sensitive to making biases. If there is no
negative correlation between the chances of becoming an executive and the receptivity to biases,
then one could conclude that executives are sensitive to biases as well. In the case of
overconfidence, Goel & Thakor (2000) argue that executives could be the individuals who are more
prone to overestimation due to overconfidence, since the financial markets may value executives
who make risk neutral decisions. As most individuals are risk-averse, overconfidence and
consequently overestimation could offset the risk aversion factor in decision-making. Moreover,
executives who underestimate risk, are more likely to encounter negatives outcomes, however,
these executives are also more likely to encounter extraordinary outcomes compared to executives
who did not invest because of a risk profile. Therefore, some overconfident executives could have
raised their profile and become CEOs.
Potential participants will be drawn from a pool of students who have an affinity with financial
economics. The reason behind this is to exclude biases due to misunderstanding of valuation
methods. The sample size should be large enough to be able to statistical inference. A small sample
could constitute problems if the distribution does not closely resemble a normal distribution, is
heavily skewed or comprises extreme outliers. Consequently, a sample should be as large as possible,
however, the following research may be bounded by a budget. A sample size of about 100
participants would be statistically sufficient, as well as not unrealistic given the budget restriction of
the experiment.
During the conduct of the experiment, the participants will answer questions individually on a
computer in a separated room. However, they should have the perception that other participants are
examined simultaneously, as this creates the illusion of competition which is necessary for some
parts of the experiment concerning auctions. The advantage of this setting is that the participants are
not able to skip ahead to next questions, since this would greatly damage the reliability of any
conclusions made from this participant’s answers, because the perception to the degree of
information offered is partly the subject of the experiment.
Introduction
Firstly, the participants will be made familiar with the type of questions they can expect, namely that
they take the role of a CEO. In this role they will make decisions which could affect their firm’s
valuation, denominated in points. Importantly, the true subject of the experiment will not be
revealed, since the goal of the experiment is to test whether participants are receptive to real
options when they are not explicitly given attention. Furthermore, the participants are informed
34
about the relationship between their actions and monetary compensation in order to motivate them
to answer the questions seriously. The participants are also informed about the fact that the points,
which represent the company’s value, are converted into their monetary compensation at the end of
the experiment. The conversion will be 100 points for € 1,-. The reason behind the valuation being
denominated in points is to prevent that the participants frame the questions in terms of real money,
which could lead to a following idea: ‘In the worst case scenario I’ll only lose €2,- by making this
decision’ whilst € 2,- represents 20% of the company’s initial value and such a loss should be
perceived as heavily in practice.
Part One
In this part, the participants will be informed about the company of which they will assume the role
of CEO in, as well as make the first business decision.
The company of which the participants are fictionally in charge, is described. This company is active
in the market of electronic devices, because this industry is characterized by the natural presence of
real options and it is most likely familiar to the participants. The latter offers the participants the
opportunity to project knowledge about this industry into their decisions. In other words, from their
own experience they could imagine certain growth and spill over opportunities inherent to this
industry. In the experiment this is enforced by naming various characteristics about the company.
First information about geographical expansion in the past is given. This is done in order to give the
participants the opportunity to be aware of the option to grow geographically. Furthermore, it is
posed that the company uses equipment some of which is rather specific to the company’s product
line, others of which have a wide array of possible applications. This implies the option to switch or
abandon. Moreover, information is presented about past successes regarding of the extension of
know how over multiple product lines, in this case the implementation of display technology on
numerous electronics devices (this might reinforce the aforementioned applicability of their real life
experiences with this industry). This again points toward growth options. Hereafter, the value of the
company at the moment of appointment as CEO is given. This value differs for all the groups,
respectively 600, 1000 and 1400. These values are provided by means of a graph, which includes
valuations of the past nine years. This is done in order to emphasize the initial value at the moment
of appointment (could be relevant for escalation of commitment). The participants are informed that
these past experiences are both attributable to chance (economic circumstances) and good
management. This remark could be relevant for the possible self-attribution of past experiences and
their influence on future decisions.
35
First order of business
The participants (groups I&III) are asked to evaluate two geographical expansion possibilities. The
purpose of this question is to get the participant in a managerial mindset as well as evoke a feeling of
responsibility for the performance of the company. In case the participants do not feel responsible,
they might think after they have been framed in a hot or cold deal market, which results in both
scenarios in a company value of 1000 points: ‘I started with 1400 points, and without doing anything
it is now 1000. So in fact I start with 1000.’ This would undermine the intended framing and is
thereby likely to significantly reduce the reliability of the eventual conclusions. Another purpose of
this question is to create the opportunity for the participants to attribute potential upcoming
successes to their own actions, which could result in overconfidence. There is no extra information
presented about the alternatives to which the company could expand, so the participants should use
their own information about the countries, which could enforce their believe that in case of
successes this due to their intelligence.
Economic upturn/downturn
The participants are given information about the performances of the last period since they were
appointed as CEOs. The members of group I will experience a gain of 400 points. The participants are
informed that this gain is caused by both economic circumstances and their previous decision
concerning geographical expansion. Deliberately, no further specifications are given regarding the
weight of these causes. Again, this gives the participants the possibility to attribute the gain to their
actions and enhance overconfidence. Members of group III will encounter a loss of 400 points, due
to their prior decision and economic circumstances as well. The ambiguity of the cause of the value
decline provides the participants the opportunity to attribute this to external factors (economic
circumstances). As earlier mentioned, the company value of both groups will eventually be 1000
points. In this way liquidity motives which could affect further investment choices, are excluded.
Summarized, group I is framed in a hot deal market (which is related to a positive economic/business
sentiment), whilst group III is framed in a cold deal market. The company value of the control groups
I and IV will remain the same, since they are not given a history of performances during their period
as CEO. In other words, the part of the experiment concerning an economic up- or downturn is not
applicable to the participants of group II & IV.
Part two
The participants will all be given the same valuation question about a potential venture. Before any
information about the venture is given, the participants are again made aware of their prior business
36
experience, in order to try to align the sentiment with the intended frame. The valuation question in
part two concerns the possibility of buying a right to use new technology which could be valuable to
the company of which the participants are in charge. The participants are informed about this
opportunity by stating that this new technology is the invention of a new resolution standard for TV
displays, which is one of the products of the company. The name of this invention is related to a
current development in the market of TV’s, so again the participants could relate to their real life
experience. The description deliberately leaves room for the idea that this new technology could be
applied to other products of the company as well. It is justifiable that the participants have this
perception, since spill over effects are not rare to the company and have proven to be successful in
the past (described in part one). The description also includes the remark that competition is
interested as well and that the licence therefore is sold in an auction. The reason behind the choice
for an auction, is to make the participants give a bid as close as possible to their reservation prices.
Otherwise, the participants might price the license in such a way that it maximizes profits later on
(and thereby their monetary compensation), in case they think that the price they offer will always
results in obtaining the licence for the price they offered. Therefore, the participants must have the
perception that other people are simultaneously participating in this bidding contest. Moreover, the
interest of the competitors could lead to the belief that this might be the only opportunity to be able
to use this technology and to position oneself in a situation of having the option to apply the
technology to other products. The description offers plenty of indications to interpret certain aspects
of the information as options to expand/grow, if participants are receptive to these options.
The valuation is based on information which enables the participants to use the DCF method. This
information exists of certain net payoffs during the planning period, an uncertain horizon value
which (graphically emphasized with a question mark), and the total outlay of the investment, which
consists of implementation costs and the price paid for the licence fee. For reasons of simplicity, the
discount factor is 0. As a result of the fact that participants have been selected based on their
affinity with financial economics, one may expect that the participants are able to interpret the
offered values correctly. An extra remark in the description is made that each year involves at least
some fixed costs. This remark has the purpose to make the participants aware of the fact that the
project could also turn out to be negative, which could alter the valuation because of the concept of
loss aversion. Providing the payoffs in the form described above, enables one to calculate the
participant’s valuation of the horizon value. Recall that an indication for overconfidence or overoptimism, as well as for narrow framing, will be reflected in a DCF method via the estimation of the
horizon value. However, the assumption that a bid reflects the participant’s reservation price has to
be made in order to calculate the horizon value. The participant’s bid is the sum of his estimations of
37
the positive and negative cash flows (except the licence fee)1. Both the implementation costs and
certain cash flows of the planning period are known, so the bid reveals the participant’s estimation of
the horizon value.
Part three
The questions in the third part of the experiment differs for the groups I & III, as well as for their
control groups. This imposed difference is done in order to test whether the participants who are
framed in a hot and cold deal market are receptive for the options which are proposed (in the
theoretical framework) to be used in these distinctive settings. The members of group I and II are
therefore confronted with questions concerning an option to defer, whilst members of group III and
IV are confronted with questions concerning an option to grow/expand.
Group I and II are informed that before the auction has taken place, they are approached by the
company which developed the new technology to start a 50% - 50% joint venture. The participants
are also informed about an important feature of this offer, namely that they are given the
opportunity to buy the other company out after six years for an amount which was half of the initial
outlay presented in the previous question. The participant should be aware that this opportunity
gives him the possibility to ‘wait-and-see’. Furthermore, the participants will be told that the
company which developed the new technology also approaches the other players. This comment is
made in order to prevent the participant to think that by refusing the offer, the auction will take
place nonetheless. Because of the latter, the participants again have to come up with a bid for the
licence fee, which could also be seen as the initial investment necessary to start the joint-venture.
One could draw the conclusion that the participants value the possibility of a buy-out, if the new bid
is more than half of the bid in the previous question. This reasoning is based on the idea that the
opportunity of starting a joint-venture implies a halving of both the initial investment outlay and
future cash flows, which should consequently result in a halving of the valuation (if liquidity motives
are neglected).
After the bid is made, the participants are faced with a fictional comment by the board of directors
that they do not agree on the current terms and they propose a slight adjustment. Namely, that the
clause allows the company to buy-out the other company at any moment after six years. The
participant as the CEO has to communicate this proposed adjustment together with a new bid for the
licence. Literature suggests that the participants should value this revised clause which constitutes an
option to stage more than the previous clause, because the nature of the revised clause gives the
1
HV = - (C0 + Licence fee + C1-7)
38
opportunity to exercise the option at the same moment as the previous clause, as well as the
possibility to postpone and wait. However, if participants are still biased by overconfidence, they may
not value the extra possibilities the new clause offers compared to the clause proposed by the
potential partner, due to the potential exuberance that they will exercise regardless of future
circumstances. Of course, this will indicate a valuation error.
The participants assigned to the groups III & IV are also confronted with new information before the
auction takes place. The participants are informed that the new developed technology for TV displays
may in the future also be applicable to the company’s smart phones. Moreover, the participants are
made aware of a comment by their R&D department that the application of the technology to smart
phones is contingent upon the acquiring and using of the licence for the production of TV’s and
thereby accumulating know how required for the production of smart phones. However, it is
uncertain whether the market for smart phones evolves in such a way that the use of the technology
for smart phones is profitable. The situation stated is a text book example of an option to grow,
because of both the potential of expanding after a certain period and the dependence of this
potential on a prior commitment. The participants are further notified that if the market for smart
phones eventually turns out to be positive for the implementation of the new technology, then the
size of the cash flows will be twice as large as the cash flows associated with the production of TV’s. If
the market for smart phones turns out to be unfavourable, the participants are informed that there
will be a certain loss for ten following years if they invest. This should not matter: if these
unfavourable conditions occur, the participant will not/should not exercise the option. It is
imperative that the participant understands that this does not affect the value of the option, he/she
should only take the upside potential into account. Again the participants are asked how much they
are willing to bid for the licence to make use of this new technology. If these bids are higher than the
bids made in the previous question, one could conclude that the participants value the possibility
which is made more explicit.
Before the last valuation by group III & IV is made, they will again encounter new information.
Compared to the previous situation in which it seemed that only after a certain period (and only
then) the market condition could be evaluated, the description of new information provides the
participant with the perception that he/she is able to evaluate and choose if an implementation of
the technology for the production of smart phones is profitable, at any point after this certain period.
The description also includes the comment that the chance for a receptive smart phone market
diminishes over time. The degree in which the likelihood diminishes over time is irrelevant, the
participants should value the new possibility of ‘wait-and-see’, compared to the setting in the
previous question. Again, this is expressed in a higher bid for the licence.
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End of the experiment
Because of the uncertainty of the outcomes related to the implementation of the licence, the
ultimate company’s value is arbitrary and provides a justification for any distribution of the monetary
payments to the participants.
Conclusion
The purpose of this article was to conduct an experiment which enables one to test whether certain
real options could be the solution for the influence of cognitive biases on the valuation process of
investment opportunities during so called hot and cold deal markets. The assumed influence of these
cognitive biases is based on the observation that the valuations of investment opportunities differ
during hot and cold deal market, without an underlying economic justification. If cognitive biases are
the reason behind this observation, then this would imply a relationship between the ‘temperature’
of the M&A market and these cognitive biases as well. In order to be able to test if the
implementation of real options provides a solution, it is required to have an answer on the question
which biases effect executives’ decision-making process and under which circumstances are
executives more prone to make systematic errors. Therefore, another part of the experiment focuses
on the testing of the existence of certain cognitive biases in different conditions of the M&A market.
This experiment is designed to test for multiple biases including: overconfidence, anchoring and
narrow framing. However, these biases could be theoretically linked to the valuation process,
through prior business experience, instead of the condition of the M&A market. Therefore, the
assumption is made that the temperature of the M&A market is positively correlated to the business
cycle and to a company’s performances as well. A situation of a hot deal market is expected to be
associated with a situation of an economic boom, which implies a prior business upturn. A cold deal
market is expected to be associated with a situation of an economic depression, which implies a prior
business downturn. These prior business experiences could be a prerequisite for the existence of
cognitive biases or an enhancing factor. These relationships have been described, since an alteration
of one these variables in an experiment, makes it possible to test whether the condition of the M&A
market could (indirectly) influence valuations of an investment opportunity. It is proposed that a
prior positive business experience could enhance the level of overconfidence, due to self-attribution
and an outsider’s view. This higher level of overconfidence could lead to an overestimation of the
horizon value when the DCF method is used. Otherwise, a negative prior business experience could
lead to more risk averse behaviour, and therefore to reticence regarding investments. However, it is
also possible that a negative prior business experience leads to more risk seeking behaviour, due to
40
the effect of loss aversion. More risk seeking behaviour could in turn lead to higher valuations and
M&A activity. It is obvious that the effect of prior business performance on cognitive biases and
consequently its effect on valuations could be contradictory. Therefore, the experiment is designed
in such a manner that it is able to test for the relationship between cognitive biases in isolation. After
this relationship has been examined, the experiment tests the participants on their ability to
recognize characteristics of real options that add value. If the participants demonstrate that they are
not able to recognize these characteristics, then one could argue if the use of real options in addition
to for example the DCF method, is useful.
The experiment tried to create a ‘real life’ setting. This could result in a situation in which
participants will put emphasize on circumstances that are not relevant for the examined relationship.
In other words, participants may come up with circumstances that are not described. However, in
order to test cognitive biases in an applied setting, the participants have to be truly involved.
Moreover, the participants have to be given the opportunity to demonstrate their overoptimistic
estimations, since this is one of the possible explanations for differences in valuations. By creating a
setting to which the participants can relate, the influence of prior business experiences could
become clear. Extensive research on the subject of cognitive biases has been conducted in a more
abstract way. However, in these experiments the existence of one bias at a time is tested. In this
experiment the combined effect of multiple biases will be tested.
However, despite the fact that cognitive biases could be the link in the relationship between the
temperature of the M&A market, there might be other causes for the overestimation of the horizon
value in a hot deal market and the reticence to invest in cold deal markets. For example, an
executive’s perception about competition for a limited pool of investment opportunities or external
influences. The experiment is unable to correct for these potential influences, since a combination of
causes is also possible. Moreover, combined with the real life setting of the experiment, participants
could use own information about the valuation and acquisition processes during hot and cold deal
market and use this for their valuation. This will be problematic in case this not all participants
reason in this way.
Further research could include performing the proposed experiment. As well as to include
corrections for other potentials causes of the relationship between the temperature of the market
and valuations. Another possible addition to this experiment might be the examination of
participants’ ability to recognize the characteristics of other real options, such as the option to
switch. If the experiments findings conclude that participants are able to recognize the value adding
characteristics of real options, one could test whether the increased ‘availability’ of real options
41
alters the valuation when confronted with a new decision. The problem of giving participants a new
task, is that they have encountered another business experience compared to the previous task. If
one assumes that prior business experience has an influence on cognitive biases, then this may alter
the valuations instead of the use of real options. Another possibility to test whether the use of real
options alters valuations of investment opportunities, is to compare the valuations made by
participants who were prior to the experiment given information about real options, to the
valuations made by participant without such given information.
42
Appendix : Experiment
Introduction experiment:
In this experiment you will be put in charge of the operational activities of a firm. You are the
CEO of a firm and you will have to make decisions regarding future ventures of the firm. This
firm has a particular valuation when you are put in charge (t=0). This valuation is given in
points. These points represent cash at the end of the experiment. Depending on your
decisions, as well as the chance state of the economy, you will lose or gain points in the
company’s valuation. At the end of the experiment, the valuation of your company (in points)
reflects your remuneration. The conversion rate is €1,- for 100 points.
Part One:
Description of your company:
You have taken over the position of CEO of KeenScreen, a company which develops and
produces screens for a number of different electronic devices. KeenScreen is headquartered
in the Netherlands, and has several foreign subsidiaries, primarily Germany and Belgium.
Furthermore, KeenScreen makes use of many different forms of equipment, some of which
is rather specific to KeenScreen’s products, others of which have a wide array of possible
applications. Due to the successful development and implementation of various
technologies, KeenScreen has established a firm position in the market. The introduction of a
new standard of high resolution screens for TVs, which has been extended to the entire
product line of KeenScreen, has accrued the company stable revenues over the past years.
KeenScreen’s valuation over the last ten years is given in the figure below. At t=0 the
valuation equals 600/1,400 points.
43
The recent revenues of KeenScreen have benefitted from the relative economic upturn. Just
like most other firms, KeenScreen is, at least in part, subject to economic circumstances. The
foreign subsidiaries of KeenScreen in other countries, predominantly Germany and Belgium,
has also attributed to the stable revenues of recent years.
First order of business:
Your first order of business as the new CEO of KeenScreen is to make a decision regarding
the possibility of expansion to a new country. The board of directors has assessed two
possible alternatives: Sweden and Norway. You now have to make a decision in which
country you want to set up a new subsidiary. Market research has provided you with little
indication as to which country might be better, so it really is up to you to make a choice.
Which country will you set up the new subsidiary?
Sweden / Norway
44
Economic upturn
It has been one year since your appointment as CEO of KeenScreen. Your decision to expand
into [Enter ‘First order of business’-answer] has turned out to be rather successful and has
mildly improved your revenues. Furthermore, an economic upturn has had a major impact
on KeenScreen, significantly improving its valuation. The figure below depicts the situation at
t=1, indicating a valuation of 1,000 points. In other words, the value has improved by 400
points.
Economic downturn
It has been one year since your appointment as CEO of KeenScreen. Your decision to expand
into [Enter ‘First order of business’-answer] has turned out to be rather unsuccessful and has
mildly worsened your revenues. Furthermore, an economic downturn has had a major
impact on KeenScreen, significantly lowering its valuation. The figure below depicts the
situation at t=1, indicating a valuation of 1,000 points. In other words, the value has declined
by 400 points.
45
Part Two:
After the good/bad/normal year KeenScreen has had, it is time for you to make another
decision. A research company, InnovaTV, has found a new technology called UltraHD, which
significantly improves the resolution standard of TV’s. This new technology has sparked a
wave of interest among competitors. Your marketing department also hinted that this new
technology may be successful. InnovaTV now wants to sell the right to use this new
technology. It wants to put the license to use the technology up for auction.
Upon your request, KeenScreen’s finance department has forecasted the cash flows
associated with the implementation of the technology in the production and sales of
KeenScreen TV’s. The forecasts are depicted in the figure and table below.
PROJECT ULTRAHD TV
Cash flow
T=1
License fee
10
15
10
5
T=2
T=3
T=4
T=5
20
T=6
10
T=7
-50
?
HORIZON
VALUE
?
?
Cash flow
t=1 (=now)
-50
License fee
?
t=2
10
t=3
15
t=4
10
t=5
5
t=6
20
t=7
10
Horizon value
?
The interest rate is 0. Values are given in points.
The values above are net values. Every time period the production and sales of TV’s with
UltraHD are associated with at least some fixed costs. Therefore, every given cash flow is the
balance of the expected costs and revenues for that period. The cash outflow at t=1 is
divided into two parts; the initial outlay (think: the purchase of machines required to
produce the new televisions, as well as setting up sales channels) and the license fee. This
license fee is the fee you have to pay to InnovaTV in order to use UltraHD technology, if you
46
win the auction. There are 10 competitors (other participants of the experiment) also
interested in UltraHD and are all planning to make a bid at the auction.
You now have to make a decision: what is the maximum amount of points you are willing
to pay in order to receive the license?
current amount of points*
47
Part Three:
Before the auction takes place, InnovaTV calls you and gives you an offer which entails a 50%
-50% joint venture. Thus, KeenScreen and InnovaTV would equally share all revenues, as well
as split all costs of the project UltraHD. Furthermore, InnovaTV is willing to provide you with
a clause which gives you (KeenScreen) the opportunity to buy out InnovaTV’s share of 50%
after six years (at the end of t=7) for the other half of the initial outlay (25). After six years,
you will have a better understanding of the market for UltraHD and will therefore have more
certainty regarding the future of the project.
For this venture InnovaTV still demands a certain license fee.
Thus, if you would agree to this offer without invoking the clause, your cash flows would be
as depicted below:
Possibility to invoke
clause for -25
Cash flow
t=1 (=now)
-25
License fee
?
t=2
5
t=3
7.5
t=4
5
t=5
2.5
t=6
10
t=7
5
Horizon value
?
Again, the interest rate is 0. KeenScreen still has the same valuation: 1,400 points.
InnovaTV has assured you that if you do not agree to this joint venture, it will approach one
of your interested competitors, therefore disabling you from doing any project related to
UltraHD.
The board of directors asks you to evaluate the offer: how much are you willing to pay for
the license?
Your board of directors has given a negative advice concerning InnovaTV’s offer. They
propose a counterbid for you which has the same characteristics as the previous bid, but
now the clause should entail the possibility to buy InnovaTV’s 50% shares at the end of t=7
or any other moment later.
Possibility to invoke
clause for -25
Cash flow
License fee
48
t=1
-25
?
t=2
5
t=3
7.5
t=4
5
t=5
2.5
t=6
10
t=7
5
Horizon value
?
You are asked to convey this new proposition to InnovaTV, together with your offer for the
license under the renewed circumstances. How much are you willing to offer for the license
under these circumstances?
Part Three:
Before the auction takes place, your R&D department informs you about possible
opportunities the production of UltraHD TV’s provides for your smart phone screen product
line. If you don’t possess the license to produce TV’s with the UltraHD technology, you will
not build the know-how necessary to implement this technology in the production of smart
phone screens. At this point in time (t=1) it is uncertain whether this technology will prove to
be the new standard for smart phone screens, or if the economic demand for smart phone
will differ from the current demand. Therefore, the potential cash flows of the UltraHD
Smartphone project are prone to uncertainty.
Your marketing department has made a crude estimation about the potential of this UltraHD
Smartphone project. They establish that the know-how required to implement this
technology in the smart phone product line will be readily available at the beginning of t=5.
If the market for this new smart phone technology turns out to be favorable, this project will
be twice the size of the project UltraHD TV’s. The probability for a favorable state of the
market is expected to be 20%. If the market turns out to be unfavorable (with a probability
of 80%), investing in this project will result in a yearly loss of 10 for ten consecutive years,
after an initial outlay of 100.
In short, the project for UltraHD TV’s now entails the following:
Know-how ready for
UltraHD Smartphone
Estimated cash flows for project UltraHD TV:
Cash flow
t=1 (=now)
-50
License fee
?
t=2
10
t=3
15
t=4
10
t=5
5
t=6
20
t=7
10
Horizon value
?
Estimated cash flows for project UltraHD Smartphone, if market is favorable:
Cash flow
t=5
-100
t=6
20
The interest rate is equal to 0.
49
t=7
30
t=8
20
t=9
10
t=10
40
t=11
20
Horizon value
?
You now have to make a decision: how much are you willing to pay for the license in order
to produce the UltraHD TV’s?
Before the auction takes place, your finance department approaches you with a new insight.
They inform you that the marketing departments’ estimation was incomplete and does not
properly reflect the possible outcomes of project UltraHD Smartphone. Even if the market
turns out to be unfavorable at t=5, there is still a chance in the following years that the
market might suddenly be receptive towards the UltraHD Smartphone. At t=5 the probability
is for a favorable market is 20%. In the following years the likelihood for a receptive market
diminishes, until t=10, where there is no more chance for a favorable market. If the market is
favorable and the investment for UltraHD Smartphone is made, this project will still be twice
the size of project UltraHD TV.
Know-how ready for
UltraHD Smartphone
Possibility for favorable market until t=10.
Estimated cash flows for project UltraHD TV:
Cash flow
t=1 (=now)
-50
License fee
?
t=2
10
t=3
15
t=4
10
t=5
5
t=6
20
t=7
10
Horizon value
?
Estimated cash flows for project UltraHD Smartphone, if market is favorable:
Cash flow
t=5
-100
t=6
20
t=7
30
t=8
20
t=9
10
t=10
40
t=11
20
Horizon value
?
The interest rate is equal to 0.
You now have to make a bid at the auction: how much are you willing to bid for the license
in order to produce the UltraHD TV’s?
50
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