Bfw2140 Corporate Finance : Capabilities Assessment Answers

a.Critically analyze some of the more prominent behavioral characteristics of decision making.
b.Describe how these characteristics create internal and external obstacles to value maximization in the context of real-world examples.

Question - a

Behavioral finance aims to combine economics, science, and financial theories to observe how people can make actual investment decisions that have the potential to influence their financial perspectives. The first and the most superior behavioral characteristic of decision-making is overconfidence that refers to the investors’ tendency in overestimating their knowledge and capabilities (Volcker, 2011). In simple words, this means that the investors with such kind of behavioral characteristic would view their capabilities to be more likely superior, and at an added advantage in comparison to their actual capabilities. While confidence refers to belief in oneself and abilities with complete conviction, overconfidence can be taken as one-step ahead in which it takes dependent behavior to an extreme (Certo, 2005). Furthermore, studies depict that people working in organizations are often overconfident in their judgments and this is one of the major causes, why they overestimate the appropriateness of their forecasts. For example, overconfident executives might underestimate the possibility of default, and ultimately choose an overly debt-heavy structure of capital. Overconfidence originates partly from the hallucination of knowledge. The mind of humans is designed to pluck as many details as possible from what is prevalent. This is the reason why investment accommodated with overconfidence, can result in risky and inaccurate investments (Scapens, 2012). The two key factors of overconfidence are better than aggregate effect and miscalibration. Such miscalibration can demonstrate itself in quality expectations that can significantly be discovered and in expectations of unknown qualities. Since overconfident individuals are not properly calibrated, in their anticipation, they set confidence in a narrower manner, thereby resulting in an unwanted outcome (Certo, 2005). Moreover, in financial markets, there are several investors, who are overconfident that they fail to trade in such a way that fail to cover the transaction costs betwixt the stock they purchase and those they sell. There are implicit and explicit assumptions regarding overconfidence being modeled in theoretical finance. While some static models with regular overconfidence assume uniform individual differences in the extent of overconfidence, some other studies refer to investors’ variant extent of confidence as various types of investor (Merchant, 2012). On a whole, people often regard their success due to their own capabilities and skills, and they consider a failure because of reasons like bad luck, etc. However, overconfidence results in higher trading in markets as it enhances risk and mistake luck for skill. Furthermore, according to psychological studies, it is shown that although many people vary in their extent of overconfidence, almost everyone portrays it to some extent. For instance, most of the individuals rate themselves as above-average drivers, but in reality, more than fifty percent of drivers are below average. This kind of behavioral characteristic is prevalent in all categories of professionals, thereby playing a key role in decision-making (Melville, 2013).

Regret aversion is the second behavioral characteristic of decision-making. This characteristic is used to explain the emotion of regret encountered after making a decision that either is an inferior one or turns out to be worst as a whole. Furthermore, it is primarily associated with how a priori expectation of potential regret can affect decision-making. Regret is the emotion an individual feels if he or she can easily think of having acted in a way that could have resulted in a more favorable result. It is not only the feeling of duty for loss but also an emotion for not having made an accurate decision (Malkiel & Mullainathan, 2005). Furthermore, in relation to financial context, the deduction of potential future regret plays a key and significant part in the allocation of portfolios. It is also associated with the preference shares regarding payment of a dividend in financing expenditures for consumers, as selling a specific stock that can enhance in the upcoming future carries an immense possibility for regret (Brigham & Daves, 2012). Moreover, avoidance of regret is a tendency to escape actions of interest that can generate complications over past decisions. Nevertheless, this clearly explains why investors often postpone selling losing positions. In order to avert the stress and complications related to admitting a grave mistake, such investors often hold on to the losing zone and expect for recovery. Further, at the same time, these investors sell the stocks that have enhanced efficiently, in order to encounter regret if there is a decline in the prices of these stocks. Such avoidance of regret can also be stated when people tend to possess more regret over the exact losses in small stocks instead of the good ones (Libby et. al, 2011). This is because the purchase of small stocks will be more of their self-made decisions that are out of favor to other people. It is a kind of decision which people take to strengthen their own view and provides self-defense. Moreover, the reason why smaller stocks necessitate a higher rate of return in the case of buying decisions is that when investors lose on such stocks, they feel more dishonest than losing on the higher ones. The regret of omission is a sorrow of not taking proper action that may fetch effective outcomes. Further, the risk of the commission is a sorrow of not taking proper action that has improper outcomes (Lapsley, 2012). On a whole, individuals (especially investors) often avoid regret or loss at every possible expense, which means that if they do not make proper investment decisions, they cannot attain their investment objectives.

The third behavioral characteristic of decision-making is associated with adjustment and anchoring. It is well known that when individuals are asked to establish a quantitative evaluation, their viewpoints can be easily affected by various suggestions. This strikes a notion that the surrounding views come into action whenever a decision is taken. In simple words, when such people are encountered with uncertainty, they will more likely to grasp at straws to seek a basis for the view (Kirman, 2009). Moreover, when people start establishing estimates, they often start with few initials, especially one that pursues arbitrary value, and then they adjust away from it. In relation to anchoring, it can be stated as a tendency to attach one’s thoughts to a point of reference even though it may not have any logical significance to the decision-making.  It influences the decision-making ability and provides a firm decision (Christensen, 2011). Moreover, when people are dealing with situations that are new, the concept of anchoring is clearly prevalent because after establishing an opinion, most of the people often desires to alter it even though they tend to procure fresh details that are more significant. In this scenario, it can be commented that even after holding a valid opinion there can be a chance of alteration. For instance, one set of investors have established an opinion associated with a company that it has above aggregate earnings prospect on a long-term basis, and suddenly such company depicts very lesser earning than the provided expectation. This is because of the concept of anchoring or conservatism, which implies that such investors will be more likely to persevere in the ideology that the above-mentioned company is operating above aggregate, and will definitely not react significantly to worst scenarios (Kaustia et. al, 2008). On a whole, such characteristic explains the common human tendency to depend too aggressively on the first piece of details provided, and during the process of decision-making, individuals start utilizing such piece of details to make the following judgments. In simple words, once an anchor is set, other relevant judgments are made by shaping away from the anchor and there prevails a bias towards interpreting other data that surrounds the anchor. For instance, according to a journal by Wall Street, 14% of Japanese investors anticipated a crash, but after it did crash in reality, 32% started anticipating a crash. This is because, when an immense population of participant becomes excessively pessimistic about the future, it depicts an indication that the opposite will happen (Deegan, 2011).

 

Answer – (b)

In relation to the behavioral obstacles to value creation that are internal to a firm, practitioners indulged in matters related to value-based management concentrate upon agency expenses that arise when there prevails a conflict of interest betwixt the agents (managers) and the principals (shareholders). Advocates of value-based management state that with efficiently designed incentives, such managers can enhance the firm value (Wagenhofer, 2014). It needs to be noted that the management needs to be equipped with the inventive technique so that they can prosper in their undertaking. However, behavioral expenses may be too much, and hence cannot be catered to by incentives alone. This concludes the fact that incentives are of very significant importance. Moreover, in relation to behavioral obstacles to value creation that are external to a firm, advocates argue that risk is not priced accordingly with the Capital Asset Pricing Model and that prices of markets often divert from significant values. These issues may be relevant to corporate decision-making and behavioral characteristics like confidence, regret aversion, etc, plays a relevant part in it (Kaplan, 2011). Furthermore, these characteristics also generate external and internal obstacles to value-maximization.

In relation to the case of Sony Corporation, the first pocket-sized transistor radio was discovered by it. Sooner, Morita and Ibuka planned to develop a color-television set wherein a technical license was negotiated by Morita to produce a color-television receiver framed around the Chromatron tube, and Ibaka on the other handled a process technology and commercial technology. However, Ibuka and his team failed to develop a commercially reliable manufacturing process. Ibuka was both confident and optimistic that allowed him to procure enthusiastic consumer reactions after the announcement of the product. Sony decided to invest in order to attain the Chromatron assembly, and Ibuka suggested the same priority. However, its retail price was $550 that was twice its production cost, and that made Morita disregard the project but the refusal from Ibuka prevented such happening. Hence, Sony continued to produce and sell Chromatron sets, thereby enhancing its losses (Kaustia, 2008). Sooner, the financial managers of Sony declared the company vulnerable and ‘close to ruin’. After such declaration, Ibuka terminated the project. This depicts the prevalence of behavioral characteristics like overconfidence and avoidance of loss in the Chromatron project. The prevalence of overconfidence is prominent because Ibuka committed the company (Sony) to produce huge masses of Chromatron sets, even though he and his team failed to develop a commercially reliable process of manufacturing. Furthermore, the avoidance of regret or loss is also prominent because even though the project started depicting loss figures, Ibuka continued the investment of resources towards the project. This shows that Ibuka was not ready to accept a sure loss and hence, preferred to gamble in order to work out an effective solution.

Most of the initial losses of Sony regarding Chromatron originated from its investment in a freshly enhanced production facility, which is sunk cost. According to academic studies, such costs are foregone and cannot be influenced by the decision whether to accept the project or not and hence must be ignored. However, corporate decision-makers often regard these costs as significant. Furthermore, it has been observed that people (Ibuka) invest more money into a failure they consider themselves responsible for, instead of investing into a success. The decision to continue investment in the Chromatron project can also be aligned to the anchoring bias as it illustrates the common human tendency to depend on the first piece of information provided. Furthermore, decision-makers who are liable for a failure can be more retrospectively aligned than those who are not liable for such failure. In simple words, such decision-makers search for proper evidence in order to confirm the accuracy of their prior decisions. Managers tend to make suboptimal corporate decisions as incentive measures fail to mold their interests with that of the principal (shareholders). Therefore, behavioral characteristics are clearly prominent in the case of Sony Corporation as it drove Ibuka’s actions, thereby representing a threat to the resources of the other shareholders of Sony. Moreover, in the case of Sony Corporation, manager Ibuka was not only the founder but also a key shareholder of the company. However, even though being awarded as a prime shareholder of the company, Ibuka could not be restricted from succumbing to regret or loss aversion and overconfidence in his activities as a manager. Therefore, there are very powerful influences that can be enhanced by other attributes like visibility. Nevertheless, the importance of incentives also play a key role, but this case clearly depicts that incentive effects cannot necessarily surpass the influence of behavioral characteristics.  There is various situation that arises in the normal course of activity and there are powerful influences too that comes into the picture. However, going by the above case it can be said that the incentive impact does not always move ahead of the behavioral features.

Another example of the behavioral characteristics that create internal obstacles to value maximization is the case of Syntex Corporation. The company being a pharmaceutical corporation was taken over by Roche Holdings Ltd. Later a senior Syntex researcher developed a new drug (Enprostil) that aimed to cure stomach ulcers. The significant market for such drug was extreme and it anticipated generating sales of $50-$100 million in a year. This made enprostil very visible in the market. However, in the later years, investment in the R&D department depicted a negative effect of such drug. In simple words, the drug made blood platelets clot in the test tube, thereby facilitating in heart attacks. Furthermore, researchers found that the drug potentially enhanced damage created from ingesting alcohol. However, the company failed to stop the production on the drug and it would be possible to speculate that aversion of regret or loss on the part of the researcher, made it complicated to terminate the project. The decision-maker actually liable for refusing to disrupt the project was the president of the research division of Syntex and vice-chairman (John Fried) as well. Even though after the development of a new drug, investment in enprostil continued, thereby increasing the danger of heart attacks. Moreover, researchers had stated that various dogs had died because of the animal testing of the drug. According to the court records, Fried constantly dismissed unfavorable reports on the drug as inflammatory and irrelevant. Further, he even testified that the death of dogs was not because of the drug but because of overdosage of the drug and other chemicals that were utilized in the procedure. Therefore, the financial interests of Fried were aligned with that of the shareholders of the company but still, he operated in such a way as if he suffered immensely from aversion of loss and overconfidence (Lapsley, 2012). Hence, just like in the case of Sony, behavioral characteristics can easily dominate financial incentives.

When it comes to behavioral characteristics that are external to the firm and create obstacles to value maximization, corporate managers encounter a different set of hurdles. Traditional researchers have taught such managers how to make appropriate decisions on capital structure and capital budgeting under the ideology that analysts and investors also operate in a rational manner. However, the managers have a different course of action and sense of action that helps them to deal with the stringent situation.  Investors behave in a rational manner that means investors always wants to attain a level of profit (Bodie et. al, 2014). Nevertheless, there prevails very strong evidence that depicts investors and analysts not always rational in nature. Furthermore, according to studies, it has been stated that a firm that enhances its revenues can also be disrupting its value. However, in the case of Herman-Miller, a contrasting effect can be observed. In the year 1995, Herman-Miller took into account an EVA-based methodology to its decision-making techniques, and this assisted it to enhance its profitability to impracticable levels. Nevertheless, instead of opting to operate the value-based management path, Herman-Miller found itself to be in conflict with the investors and analysts operating in the firm. According to the CFO of Herman-Miller, analysts exerted pressure on the firm to make an acquisition that could play a key role in generating earnings, even if the economic value was compromised. According to such analysts, the deal could have enhanced the EPS of the firm, but it was not willing to take it. This was not a major concern for the CFO of Herman-Miller to have treated in a light manner. Whilst some studies depict that stock returns are more interconnected to accounting earnings than to its EVA, the CFO of Herman-Miller was capable of convincing one of the most dubious analysts about the EVA evaluation (Goyal & Wahal, 2008). This does not conclude that EVA often surpasses issues in Herman-Miller that originates from revenues.

The CFO illustrated another alternative when the firm was evaluating an online initiative that could have played a significant role in creating value. Nevertheless, the entire team of the firm was unwilling to progress due to the negative influence the initiative would have had on the short-term EPS of the shareholders (Goyal & Wahal, 2008). They all identified that their unwillingness originated from the accounting considerations instead of considerations of cash flow, and was associated with the ideology that the exported items would have been capitalized instead of being expensed. This depicts that the decision of the financial managers of Herman-Miller was based on how the economic implications of their decision were packed. Nevertheless, the behavioral characteristics like overconfidence in the case of analysts and investors make them susceptible to select inferior options, thereby create a wedge betwixt market prices and significant values. This reflects that the overconfidence and mismanagement in some way disrupt the normal functioning and at times leads to losses (Hand, 1990). This is the reason why managers then find themselves unconfident of how to tackle such behavioral errors of investors and analysts, into their own decision-making. Therefore, because of the behavioral characteristics, rational managers are assumed to observe mispricing and make decisions that can encourage or motivate such mispricing (Jones & Netter, 2008). At times some decisions are undertaken that might not go in the best books and create a bad result. Furthermore, while their decisions can play a key role in maximizing the short-term value of the company, they can also result in lower long-run values as prices are appropriate (Graham & Smart, 2012).

 Therefore, board members and managers must identify the two prime behavioral obstacles in the process of maximization of value, one that is external to the firm and the other internal. It is due to the fact that both play an equal part in the process of maximization.  On one hand, the internal obstacles primarily deal with behavioral costs that originate from psychologically persuaded errors made either by employees or by managers. It dwells in the mind and opinion. There is no physical presence but there occurs a certain state of mind that damps the smooth functioning and ultimately leads to an error (Weston, 1990). On the other hand, the external obstacles originate from the psychologically persuaded errors that are only made by the analysts and investors as a whole. Moreover, the behavioral characteristics like overconfidence, loss or regret aversion, anchoring, etc, play a key role in creating obstacles in value maximization, and it is vital for managers and board members to be engaged in efficient group strategies that can play a key role in addressing behavioral costs (Kalpan & Schoar, 2005). Hence, it is imperative that the behavioral features should be constantly observed because it leads to a slowdown in the process of wealth maximization. The engagement of board members is crucial because managers tend to become vulnerable during the acceleration of commitment in big visible projects. Therefore, it is essential for the management peep into the behavioral features and addresses the problem.

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