The Value Of A Firm

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02 Nov 2017

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Word Count: 3520 excluding references and diagrams

Traditional finance assumes that all market participants are rational, self-interested, maximisers of utility (the homo

economicus view). Yet this does not conform with the market anomalies and puzzles that we witness today; if agents were rational, security prices would respond quickly and accurately to new information, and market over/under-reaction and departures from fundamental values would not occur. Simon (1979) stated that humans are not computers when processing information and that heuristics play a part. Humans cannot have perfect rationality and instead have bounded rationality to take into account the cognitive limitations of both knowledge and mental capacity. Behavioural finance was therefore created in the 1980s, incorporating human biases into finance and examining the 'real world' decision making of individuals in the financial markets.

Behavioural corporate finance is a fairly recent development in comparison, researchers recognised that biases affecting investors and managers may also affect corporate decision making such as investment appraisal, capital structure and dividend decisions. Behavioural corporate finance is divided into two parts; the first looks at rational managers and their behaviour when faced with irrational investors - where the fundamental value and market value of stocks do not align. In this approach, the manager is required to balance three conflicting goals: maximisation of fundamental value, maximisation of market value, and exploitation of current mispricing to transfer wealth to existing investors (Fairchild 2007). Graham and Harvey (2001) stated that "two thirds of CFOs of public corporations believe that market mispricing is an important factor in their decision to issue stock". The second approach focuses on irrational managers, where they believe they are rational and are maximising firm value but actually are deviating from this goal (Baker et al, 2007), and how their optimism and overconfidence affects capital budgeting and capital structure decisions. In this essay the second approach will be focused on, looking at how managerial overconfidence affects firm value.

Overconfidence

Amongst all the cognitive biases to which humans fall victim, it is argued that overconfidence is the most catastrophic; leading to lawsuits, strikes and stock market bubbles and crashes. Managerial overconfidence relates to the underestimation of the risk or variance of future events, referring to the managers overestimation of his ability to predict the successful outcome of a project. Agents are more likely to be overconfident when a task is very risky, complicated and when they are committed to the task. Deaves et al (2005) stated that "overconfidence arises when knowledge perception exceeds its reality", and by using the ZEW Finanzmarkttest survey, they found that recent success increases overconfidence and recent failure mitigates overconfidence to the same degree. Skala produced a literature review in 2008 on the overconfidence phenomenon, finding that puzzles in the financial markets can be explained at least partly with mention to overconfidence. Overconfidence is also referred to as miscalibration, this is the tendency to believe that your knowledge is more accurate than it really is (Gervais et al, 2003).

Optimism is another bias which has received a large amount of attention from scholars over the last decade, this is described as an overestimation of the probability of desirable outcomes and the underestimation of the probability of undesirable outcomes. Heaton (2002) finds that the actual cash flows of firms with optimistic managers tend to fall short of their forecasts. Overconfidence also relates several other branches of literature, such as the better-than-average-effect, the tendency of individuals to consider themselves above average. ADD OTHERS.

Managers of companies are particularly susceptible to both biases, this is mainly due to their high level of control and degrees of commitment (Malmendier and Tate, 2005). Ben, Graham and Harvey (2007) found that financial executives are overconfident, only realising market returns within their 80% confidence interval 38% of the time. They found that these intervals were especially narrow following high stock market returns as managers condition their overconfidence based on past stock market performance. According to Ackert & Deaves (2010), the process of CEO selection and corporate governance policies will also encourage CEO overconfidence. It has been seen that corporate governance exacerbates any hidden tendencies; the tendency for investors to sell if they are unhappy with management encourages overconfidence, and generous executive compensation signals success which then increases overconfidence. This is also known as the self-attribution bias, this states that risky outcomes are a combination of skill and luck and managers believe that bad outcomes are attributed to bad luck, whereas good outcomes are due to skill. Gervais et al (2003) also stated that there is a selection bias, and so only those who are overconfident will apply for management positions.

This managerial overconfidence will effect shareholders in multiple ways, this essay has been split into two sections to explain these consequences to shareholders, through corporate decision making in relation to the firm's capital structure, and through investment appraisal decisions.

Investment Appraisal

Behavioural corporate finance explores the effects of overconfidence in relation to the traditional view on investment appraisal. Net present value (NPV) is the discounted stream of future cash flows of a project, a manager should only take a project if the NPV is greater than 0. However due to loss aversion, investors may throw good money after bad. Research has established that there is a positive relationship between corporate investment and cash flow. However, traditional finance states that in a perfect market all positive NPV projects should be taken, and so this should not be observed. These distortions can be explained by two explanations. Firstly, by the potential misalignment of managerial and shareholder interests; this induces over investment when free cash is available, as managers want to empire build and provide themselves with perks. Secondly, the firm managers aim to act in the best interest of the shareholders, and so restrict external financing in order to avoid diluting the company's shares. A Financial Executive International survey (2003) concluded that most financial executives believe that their stock is undervalued, and only 25% of managers believe it to be correctly valued.

Overconfidence is the widely supported explanation for the distortion from traditional finance, Malmendier and Tate (2005) suggest that optimistic managers tend to overestimate returns and will over invest if they have surplus internal funds. If lacking in these funds they will not invest, thinking the market undervalues their stock. Therefore, overconfident managers are happy to expose themselves to their specific risk, thinking that their firms will perform well in the future. To counter this, CEOs often receive compensation such as stock and option grants to ensure interests are aligned with share holders. However, Gervais, Heaton and Odeon (2003) explained that managers may delay investing too long due to these executive stock options. Shefrin (2007) stated that if a CEO holds their stock options until expiration then they are overconfident, they believe that their stock is worth more than it is and so will not exercise even if the stock is in-the-money. Malmendier and Tate (2005) created a model to apply this measure of overconfidence, they found that some CEOs would hold their stock options to expiration as well as participating in many acquisitions, for example Wayne Huizenga, the former CEO of Blockbuster, qualifying him as overconfident. Whereas a rational CEO would not hold stock to expiration and would not do any deals, J. Willard Marriott, the CEO of Bethesda, was one of these. They also found that those CEOs which were characterised in the media as overconfident or optimistic, were more likely to do deals.

Managerial overconfidence also effects corporate decisions relating to dividends and to mergers and acquisitions. Ben, Graham and Harvey (2007) and Malmendier and Tate (2005) found that those firms with overconfident managers invest more and engage in more acquisitions. This may not necessarily be a good thing for the company, as failure rates of mergers and acquisitions are between 70-80% (Harvard Business Review, 2011). During a merger or an acquisition, both the bidder and the target management can experience management overconfidence. There is evidence that an overconfident bidder is more likely to conduct M+A than a rational bidder, despite the high failure rate. Moeller, Schlingemann and Stulz (2004) also found that overconfidence has a significant impact on both the short and the long term performance post M&A; during 1980-2001, $220 billion was lost immediately after bid announcements. Ackert and Deaves (2010) suggest another argument, that overconfidence actually decreases M+A. Overconfident managers tend to believe that their firms are undervalued, they are less likely to engage in M+A if they need external financing.

Overconfidence can be beneficial to a company's investment appraisal decisions. Managers are naturally risk averse and so they may reject risky projects which are good from the shareholders view point. Goel and Thakor (2000) believed that overconfidence may cause managers to accept these projects and so offsetting the risk aversion. Gervais et al (2003) found overconfidence also causes managers to hesitate less when thinking whether to invest in a project, thus increasing shareholder value. Henry Ford is a perfect example of where overconfidence has caused firm value to increase. In 1932, he presented his engineers with the task of creating the V-8motor engine in one block. Although every employee agreed that it was an impossible task, Henry Ford was confident it would succeed and so insisted they produce it anyway. As a result the world's first V-8 engine in one block was created, becoming a hit with the public and lowering the price of cars (The Fordyce Letter, 2011).

It is also argued that overconfidence is good for innovation, Gervais and Goldstein (2004) stated that it leads to better functioning organisations due to increasing productivity. The most famous example of this is Steve Jobs, whose overconfidence allowed meant that he could develop new products for Apple with less fear of failure, allowing him to achieve innovative success.

Gervais et al (2003) used a real options framework to consider risk aversion with overconfidence. If faced with a range of different projects, managers do not have the capability to analyse each option in detail and so instead economise on effort and resources. This can lead to good projects being missed. Instead of using a static, NPV approach to decision making, real options can be used to give managers flexibility. These alter the projects value added by including the option to delay, abandon and expand with the static NPV. However in the real world, managers do not use this approach much and it is generally only in pharmaceutical companies where the approach is adopted. Overconfidence can cause managers to find it difficult to abandon failing projects, the cognitive bias known as project entrapment. An example of this is the Concorde investment in 1962, due to overconfidence, costs were underestimated by over 1000% causing the project to be a failure (Jennings, 2012). The project was continued long after it was known to be uneconomic due to the commitment of 'sunk costs' causing the managers to become risk seeking and preventing them from cancellation. PROSPECT THEORY.

Statman and Tyebjee (1985) and Heaton (2002) argued that overconfidence is bad for investment decisions, stating that it leads managers to overestimate the NPV of new investment projects and causing them to invest in negative NPV projects. Figure 3 shows how an over confident manager could take a negative NPV project, while believing that it has a positive NPV, hence reducing firm value.

Figure 3: Overconfident NPV

Project

NPV

True NPV

Overconfident NPV

Ben, Graham and Harvey (2007) agree with these arguments, noting that overconfident managers use low discount rates when valuing future cash flows and so invest in projects which have lower internal rates of return than rational managers. Goel and Thakor (2000) stated that although overconfidence offsets risk aversion, it may cause managers to invest too early. To place this into context, a perfect example of overconfidence being detrimental to a firm's value is the case of Iridium and Motorola in 1987. Motorola had envisioned the idea to use a global satellite system to create a worldwide telephone network. When suggested to the top executives of the company, they approved the project straight away, even though it was very ambitious and required a large capital investment. The executives trusted their own judgement and overconfidence over financial analysis and did not even ask for any cash flow forecasts or NPVs. A new firm Iridium was created which required large investment making it the largest private sector projects in the world. However this proved to be a commercial failure and they filed for bankruptcy within a year.

Research has also been made in relation to the effects of overconfidence on dividends, Ben, Graham and Harvey (2007) found that overconfident managers are less likely to pay dividends, and would prefer to use the funds to make investments instead. Cordeiro (2009) also stated that overconfidence leads to lower dividends. Conversely, Wu and Liu (2008) and Bouwman (2010) established that overconfidence increases dividends, however there is little research into this field and so effects are unknown.

A final point to make regarding how overconfidence can affect decision making is during start ups, 81% of small businesses believe their chance of success is 70% or higher, and 33% are sure they will succeed, whereas 75% actually fail within five years. Overconfident venture capitalists could be partly to blame, Zacharakis and Shepherd (2001) argued that, due to time and resource constraints, venture capitalists may be overconfident in their ability to evaluate business plans and causing them to invest in far too many bad ventures and rejection of potentially good projects.

Capital structure

The value of a firm is calculated as the value of debt plus the value of equity, the capital structure of a firm describes how leveraged the firm is. When looking at traditional capital structure research, Miller and Modigliani (1958) believed that, without tax, the firm value is independent of the capital structure. However this assumed that there are perfect capital markets, all managers are rational, there are no taxes, there is symmetric information and the investment and financing decisions are separate. In reality, there is asymmetric information in companies, agency costs do exist and there is risky debt to worry about. Other researchers delved deeper into the relationship between capital structure and firm value, adding in imperfections such as bankruptcy costs, tax and agency costs. It was Jensen and Meckling (1976) who considered agency costs, where managers make self interested actions for monetary rewards and private benefits which are not consistent with maximising the value of the firm.

Behavioural corporate finance examines the effects of overconfidence on the capital structure of the firm and how it can lead to inappropriate capital budgeting techniques being favoured. Jensen (1986) predicted that young firms with lots of good investment opportunities should have low debt and high free cash flow, whereas those without should have high debt and low free cash flow. Damodaran (2001) agreed that a firm's capital structure decisions are not constant, but are dynamic over the life cycle of the firm.

Fairchild (2009) discusses both the early stage model and the later stage model of a firms life cycle. In the case of the early stage, where the firm has free cash flow available for investment and where many investment opportunities are available, the overconfident manager will chose lower debt than the rational manager, perceiving the new project to be value increasing and so reducing debt in order to make the investment. It provided the result that managerial overconfidence and debt may be negatively related. The effect of the higher debt on the firm value is unclear, a project that may have been value-reducing under a rational manager could be value increasing under an overconfident manager, due to the overconfident manager exerting higher effort. The later stage model is where fewer investment opportunities are available, the role of debt becomes more important and so an overconfident manager may choose higher debt than a rational manager. These models concluded that life-cycle debt is sensitive to overconfidence, and that sensitivity can increase over time as overconfidence increases due to time and experience.

Figure 1: Effect of Managerial Overconfidence on Life-cycle Debt

Time

Debt

Rational Manager

Overconfident Manager

The premise of this essay is to examine whether managerial overconfidence is good for shareholders; it is therefore logical to focus on the later stage model where debt is higher than the rational manager, as this is where the majority of firms with shareholders will be. The increase in debt can be advantageous for shareholders, due to the inside information which managers have, the capital structure has signalling properties as to the running of the company (Akerlof 1970). Ross (1977) noted that good managers tend to have more debt; this is because, if the firm were to issue debt, then managers own more equity and so request less perks, reducing moral hazard problems and so increasing the firm's value. Myers and Majluf (1984) supported this finding that the announcement of a new equity issue signals that assets are overvalued. In 1986, Jensen concluded that debt reduces the free cash flow problem. Usually managers would invest in many negative NPV projects to build their empire which would reduce firm value, however debt reduces this cash in excess of that required to fund all NPV projects so managers cannot do this. Stultz 1990 stated that the optimal level of debt is where there is enough free cash flow for good projects but not for bad ones. According to Hackbarth (2004), the natural tendency to shy away from debt due to job concerns is counteracted by the presence of overconfidence, value adding for the firm as the benefits of debt are exhausted. He also stated that debt can be value adding to a company due to the tax shield benefits which debt possesses.

However this increase in debt can also have adverse effects, overconfidence may cause firms to have an excessive level of debt in their capital structure (Shefrin 1999). This will be value reducing to the firm due to the increased financial distress costs of not recovering the interest payments. Fairchild (2009) describes a model examining the combined effects of managerial overconfidence and moral hazard. The model considered specific agency problem of managerial shirking, concluding that the manager may take high debt as a commitment device, the increase in financial distress costs driving him to a higher effort level. However, an overconfident manager will overestimate his ability and will underestimate financial distress costs. This theoretical model concluded that the effect of overconfidence is ambiguous, although the increased debt had a positive effect on firm value through inducing higher managerial effort and increasing the probability of success, it may also lead to excessive debt and higher expected bankruptcy costs. There is therefore a trade off between the managerial effort levels and the financial distress costs, suggesting that there is an optimal level of overconfidence for a firm. If the levels of debt increase too much, the manager will work harder and harder, becoming out of his depth and driving down value (Jensen and Meckling 1976). Figure 2 shows how below the optimum level, an increase in overconfidence and therefore an increase in debt will cause a firms value to increase.

Figure 2: Optimal Level of Overconfidence and Debt

Firm Value

Managerial Overconfidence

Increased debt and higher effort - effort dominates

Financial distress effect dominates

Concluding Remarks

The effects of overconfidence on firm value are still unclear today. Current literature suggests that a moderate level of overconfidence could have a positive effect on firm value. It causes firms to have greater innovation, higher effort levels due to the increased debt, and so giving them a lower cost of debt. It seems that overconfidence among entrepenuears is socially beneficial to society. However conflicting studies suggest that overconfidence induces a suboptimal leverage and investment level and suboptimal decisions. Skala (2008) stated that there are not yet answers to such questions as whether overconfidence effects are positive or negative, or if there exists an optimal level of managerial overconfidence. Barber and Odean (XX) suggest that males, the highly educated and those with higher income are more overconfident, so a possibility to reduce overconfidence could be to employ more rational individuals into management. To further analyse this conundrum, future research could be carried out into the optimal level of overconfidence, including other biases such as the refusal to abandon and using hyperbolic discounting.



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