Behavioral Corporate Finance: A Survey

Abstract

Research in behavioral corporate finance takes two distinct approaches. The first emphasizes that investors are less than fully rational. It views managerial financing and investment decisions as rational responses to securities market mispricing. The second approach emphasizes that managers are less than fully rational. It studies the effect of nonstandard preferences and judgmental biases on managerial decisions. This survey reviews the theory, empirical challenges, and current evidence pertaining to each approach. Overall, the behavioral approaches help to explain a number of important financing and investment patterns. The survey closes with a list of open questions.

What drives acquisitions?

“…Managers may be infected with the same optimism as investors during hot markets. If this is the case, then they might overestimate the synergies from a merger, leading them to make more (ex post) bad acquisitions during hot markets, consistent with Baker, Ruback and Wurgler (2007) who argue that investor inefficiency co-exists with managerial irrationality. Alternatively, managers may use hot markets as a cover to exploit shareholders.…”

“…In addition, Rosen (2006) provides evidence that investors" reaction to a merger announcement during a particular period of time can be influenced by their overly optimistic beliefs about the future prospects which lead to merger momentum. Finally, Baker, Ruback and Wurgler (2007) survey a number of papers in behavioral corporate finance and provide a framework which suggests that investor sentiment co-exists with managerial overconfidence (hubris). 1 Given the fact that high merger activity correlates with high stock market valuations, the understanding of stock market valuations is crucial to shed light on merger activities and acquirers" performance.…”

Endogenous bank mergers and their impact on banking performance

“…A popular explanation for this blatant inconsistence is managerial hubris. Roll (1986) pioneered this "hubris" theory of M&A activities stressing "that successful acquirers may be optimistic and overconfident in their own valuation of deal synergies, and fail to properly account for the winner's curse" (Baker -Ruback -Wurgler, 2004). …”

CEO overconfidence and dividend policy

“…The literature on behavioral corporate finance that examines the relation between corporate policies and the behavioral characteristics of corporate managers and investors is surveyed by Baker, Ruback, and Wurgler (2007). Ben-David, Graham, and Harvey 3 (2007), Hackbarth (2008), Tate (2005, 2008), and Malmendier, Tate, and Yan (2007) examine the effect of overconfidence in top executives on corporate finance policies.…”