Ch. 4: Behavioral Corporate Finance 151
We leave out the budget constraint, lumping together the sale of new and existing shares.
Instead of explicitly modeling the flow of funds and any potential financial constraints,
we will consider the reduced form impact ofeon fundamental value.
It is worth noting that other capital market imperfections can lead to a sort of cater-
ing behavior. For example, reputation models in the spirit ofHolmstrom (1982)can
lead to earnings management, inefficient investment, and excessive swings in corpo-
rate strategy even when the capital markets are not fooled in equilibrium.^3 Viewed in
this light, the framework here is relaxing the assumptions of rational expectations in
Holmstrom, in the case of catering, andMyers and Majluf (1984), in the case of market
timing.
Putting the goals of fundamental value, catering, and market timing into one objective
function, the irrational investors approach has the manager choosing investment and
financing to
max
K,eλ[
f(K,·)−K+eδ(·)]
+( 1 −λ)δ(·),whereλ, between zero and one, specifies the manager’s horizon. Whenλequals one,
the manager cares only about creating value for existing, long-run shareholders, the last
term drops out, and there is no distinct impact of catering. However, even an extreme
long-horizon manager cares about short-term mispricing for the purposes of market
timing, and thus may cater to short-term mispricing to further this objective. With a
shorter horizon, maximizing the stock price becomes an objective in its own right, even
without any concomitant equity issues.
We take the managerial horizon as given, exogenously set by personal characteristics,
career concerns, and the compensation contract. If the manager plans to sell equity or
exercise options in the near term, his portfolio considerations may lowerλ. However, the
managerial horizon may also be endogenous. For instance, consider a venture capitalist
who recognizes a bubble. He might offer a startup manager a contract that loads heavily
on options and short-term incentives, since he cares less about valuations that prevail
beyond the IPO lock-up period. Career concerns and the market for corporate control
can also combine to shorten horizons, since if the manager does not maximize short-run
prices, the firm may be acquired and the manager fired.
Differentiating with respect toKandegives the optimal investment and financial
policy of a rational manager operating in inefficient capital markets:
fK(K,·)= 1 −(
e+1 −λ
λ)
δK(·),−fe(K,·)=δ(·)+(
e+1 −λ
λ)
δe(·).(^3) For examples, seeStein (1989)andScharfstein and Stein (1990). For a comparison of rational expectations
and inefficient markets in this framework, seeAghion and Stein (2006).