Ch. 4: Behavioral Corporate Finance 147
- Introduction
Corporate finance aims to explain the financial contracts and the real investment be-
havior that emerge from the interaction of managers and investors. Thus, a complete
explanation of financing and investment patterns requires an understanding of the be-
liefs and preferences of these two sets of agents. The majority of research in corporate
finance assumes a broad rationality. Agents are supposed to develop unbiased forecasts
about future events and use these to make decisions that best serve their own interests.
As a practical matter, this means that managers can take for granted that capital markets
are efficient, with prices rationally reflecting public information about fundamental val-
ues. Likewise, investors can take for granted that managers will act in their self-interest,
rationally responding to incentives shaped by compensation contracts, the market for
corporate control, and other governance mechanisms.
This paper surveys research in behavioral corporate finance. This research replaces
the traditional rationality assumptions with potentially more realistic behavioral as-
sumptions. The literature is divided into two general approaches, and we organize the
survey around them. Roughly speaking, the first approach emphasizes the effect ofin-
vestorbehavior that is less than fully rational, and the second considersmanagerial
behavior that is less than fully rational. For each line of research, we review the basic
theoretical frameworks, the main empirical challenges, and the empirical evidence. Of
course, in practice, both channels of irrationality may operate at the same time; our tax-
onomy is meant to fit the existing literature, but it does suggest some structure for how
one might, in the future, go about combining the two approaches.
The “irrational investors approach” assumes that securities market arbitrage is imper-
fect, and thus that prices can be too high or too low. Rational managers are assumed to
perceive mispricings, and to make decisions that may encourage or respond to mispric-
ing. While their decisions may maximize the short-run value of the firm, they may also
result in lower long-run values as prices correct. In the simple theoretical framework
we outline, managers balance three objectives: fundamental value, catering, and market
timing. Maximizing fundamental value has the usual ingredients. Catering refers to any
actions intended to boost share prices above fundamental value. Market timing refers
specifically to financing decisions intended to capitalize on temporary mispricings, gen-
erally via the issuance of overvalued securities and the repurchase of undervalued ones.
Empirical tests of the irrational investors model face a significant challenge: mea-
suring mispricing. We discuss how this issue has been tackled and the ambiguities that
remain. Overall, despite some unresolved questions, the evidence suggests that the ir-
rational investors approach has a considerable degree of descriptive power. We review
studies on investment behavior, merger activity, the clustering and timing of corporate
security offerings, capital structure, corporate name changes, dividend policy, earnings
management, and other managerial decisions. We also identify some disparities between
the theory and the evidence. For example, while catering to fads has potential to reduce
long-run value, the literature has yet to clearly document significant long-term value
losses.