Chapter 2 Introduction to Behavioral Analysis
Learning Objectives
1. Identify the key biases that lead managers to make faulty financial judgments about
risky alternatives.
2. Explain why reliance on heuristics and susceptibility to framing effects render
managers vulnerable to making faulty decisions that reduce firm value.
3. Recognize that investors are susceptible to the same biases as managers and that
mispricing stemming from investor errors can cause managers to make faulty
decisions that reduce firm value.
Traditional Treatment
• Standard textbook approach to project selection revolves around DCF.
• In theory, managers serve the interests of investors, the owners of the firm.
• Objective function is Adjusted Present Value (APV).
– APV = sum of PV of firm’s after-tax cash flows from operations and
investment, the value associated with financing strategy, and net benefits
associated with managerial interests such as compensation and perquisites.
• It is simple if capital budgeting, capital structure or managerial compensation are
independently decided. However, in practice, there are interactions.
Behavioral Treatment Pitfalls Impacting Managers
• Psychological pitfalls might prevent managers from perfect maximization.
• Managers may judge value differently, and distort prices.
• Hence we say that prices reflect sentiment
Managerial Response to Sentiment 管理层对情绪的反应
• Sentiment: psychological pitfalls distort market prices.
• Catering entails actions (by managers) that exploit sentiment in order to increase a
firm’s stock price.
• Market timing entails actions that take advantage of mispriced securities, such as
issuing new equity when stocks are overvalued.
BPV
• Behavioral APV, Behavioral APV, incorporates the impacts of
– psychological phenomena that impact managers directly; and
– the effects that stem from catering and market timing.
Behavioral Pitfalls Box
• Examine the complete Behavioral Pitfalls box that appears on page 45.
• What behavioral phenomena come to mind as you read its contents?
Behavioral Pitfalls Scott McNealy and Sun
• BusinessWeek uses the following adjectives to describe Scott McNealy:
– optimistic.
– smart.
– acerbic.
– Cocky.
– combative.
McNealy became Sun’s CEO in 1984
Risk taker
Resisted cost cutting in recession
Internet underhyped
Cisco (competitor) lay off staffs
Cobalt takeover
Sun’s stock price
Excessive Optimism A Short Recession
• McNealy predicted that the 2001 recession would be short and he delayed cutting
costs.
• U.S. economy entered recession in March 2001, and lasted 9 months, a period that
was neither brief nor atypical.
• Between World War II and 2000, the average length of a U.S. recession was 11.6
months.
– The recession before 2001 occurred in 1990-1991, and featured two
consecutive quarters of negative growth in real GDP.
• Was McNealy excessively optimistic?
Excessively Optimistic Investors?
• During the stock market bubble between January 1997 and June 2000, irrational
exuberance drove up the prices of both the S&P 500 and Sun’s stock.
• No firm the size of Sun has historically merited a price-to-earnings ratio (P/E) over
100.
• In March 2000, at the height of the bubble, Sun’s P/E reached 119.
• Were investors excessively optimistic?
Overconfidence About Ability
• People who are overconfident about their abilities think they are better than they
actually are.
• Cockiness 自负 is a symptom of overconfidence.
• Overconfident managers make poor decisions about both investment and mergers and
acquisitions, when their firms are cash rich.
• Consider Sun’s increased spending on research and development in 2000 and its
acquisition of Cobalt (low-cost server manufacturer) are cases.
• Does this behavior suggest overconfidence about ability?
Overconfidence About Knowledge
• McNealy was confident that the 2001 recession would be sharp-edged.
– a sharp downturn followed by a sharp upturn.
• Was it, and was McNealy overconfident about his knowledge?
Confirmation Bias
• In late 2000, some Sun executives proposed a cost cutting program for Sun, after
learning that industry leader Cisco Systems' revenues were declining dramatically.
• In March 2001, Cisco Systems laid off 18% of its workforce.
• Did Cisco’s announcement disconfirm McNealy’s view about recessions being short?
• Did confirmation bias play a role in McNealy’s refusal to approve any cost cutting at
Sun?
Illusion of Control
• In 1997, Sun could purchase Intel’s chips for 30% less than what it cost them to
produce their own comparable chips.
• Despite the desire of some Sun executives to “buy” Intel chips instead of “making”
their own, Scott McNealy felt that Sun’s chip design group exerted enough control to
close the gap.
• In retrospect, McNealy describes his decision about not using Intel chips as one of his
biggest regrets.
• Is McNealy’s behavior consistent with the illusion of control?
Representativeness
• The Internet represents the overall economy.
• Representativeness-based reasoning might lead someone to conclude the following.
• The U.S. economy as a whole will experience brief sharp swings rather than rolling
waves because of
– the growing importance of the Internet in the economy; and
– Internet firms experience brief sharp swings in business conditions.
• Is this train of thought consistent with representativeness-based reasoning?
Availability
• Sun’s upper level executives communicated their concerns that the Microsoft suit had
distracted McNealy from focusing on the needs expressed by Sun’s customers.
• Customers had been asking for low-end servers in order to cut costs during the
downturn.
• With Microsoft dispute on his mind during that time, McNealy paid little attention to
customers’ requests, they were not salient.
• Is McNealy’s behavior consistent with availability bias?
Anchoring and Adjustment
• During its most successful period, Sun’s earnings growth rate reached 50% per
quarter.
• In forming forecasts going forward, how to adjust relative to the 50%?
• Suppose Sun’s executives became anchored on the 50%.
• If true, what would the impact of anchoring be on Sun executives’ forecasts of
earnings growth? It won’t be far from 50% even if the future does not look good.
Affect Heuristic
• Michael Lehman joined Sun’s board of directors in 2002, and before that he was
Sun’s CFO.
• In 2000, Lehman described Sun’s decision process for making acquisitions as follows:
Now, in determining the price we are willing to pay for such acquisitions, we are not
nearly as formal as the corporate finance textbooks suggest we perhaps ought to be. Our
approach to acquisition pricing is more intuitive.
• Is Lehman’s statement consistent with his relying on the affect heuristic?
Sun’s Endgame
• Subsequently, Sun’s losses continued to mount, with net income still negative in 2005.
• In 2006, Scott McNealy resigned as CEO and was replaced by Sun’s chief operating
officer Jonathan Schwartz.
• Sun announced that over the subsequent six months it would lay off 4,000 to 5,000
employees, comprising 11 to 13% of its work force.
Acquired by Oracle
• In May 2009, Sun agreed to be acquired by software firm Oracle for $7.4 billion.
• In June 2009 its net income was again negative, at –$2.23 billion.
• Sun announced that it planned to reduce the number of its employees by 6,000, from
33,000.
Fortune Magazine Interview With McNealy
• McNealy stated that during the technology bubble, Sun’s stock price was about 10
times its revenue, which for a hardware company was unsustainable.
• He pointed out that Sun had monetized the valuation very well.
• He said that perhaps he might have tried to talk the analysts into not running up Sun’s
stock to the extent that they did.
• He mentioned the delay in his hiring of a (dedicated) COO.
Behavioral Pitfalls Box
• Examine the complete Behavioral Pitfalls box that appears on page 45.
• What behavioral phenomena come to mind as you read its contents?
Framing Effects Judy Lewent and Merck
• In 1994 Judy Lewent, the CFO of pharmaceutical firm Merck & Co., was one of the
most respected CFOs in the United States.
• In 2004, CFO magazine ran an article entitled “What Will Judy Do?” asking whether
she would be able to keep her job.
• What happened?
• Merck was forced to withdraw its blockbuster drug Vioxx after findings that it caused
heart attacks and strokes in some patients.
Loss Aversion, Aspirations?
• In the traditional approach to debt policy, managers balance the benefits of additional
tax shields against the costs of possible future financial distress stemming from
excessive debt.
• Does Merck’s debt policy suggest the influence of loss aversion or aspiration-based
risk behavior?
Aversion to a Sure Loss
• In 1999, five of Merck's most successful products were due to go off patent in 2000
and 2001.
• The results from its post-approval clinical study, indicated that Vioxx might actually
cause heart attacks and strokes.
• Did Merck choose to try and beat the odds and go for high revenues by targeting the
whole population instead of being conservative and only targeting those with sensitive
stomachs?
Aftermath
• In August 2005, a Texas jury found Merck liable for the death of a 59-year-old
marathon runner, and awarded the victim’s family $253 million.
– This was the the first of the Vioxx trials.
• Merck’s market capitalization fell by 7.7%.
– Analysts’ estimate of the value of Merck’s legal liability increased to $30
billion, raising questions about Merck’s long-term ability to survive.
Frazier to the Rescue
• In the end, Merck’s chief counsel Kenneth Frazier crafted a strategy that framed the
scientific issues for juries in ways jury members found intuitive.
• Merck won a series of important Vioxx cases, and in 2007 reached a $4.85 billion
settlement with most of the remaining plaintiffs.
• Two years after having withdrawn Vioxx, Merck’s stock price rebounded.
Corporate Nudges
1. View decision tasks broadly, rather than narrowly, remembering that over the course
of a lifetime, risks are faced repeatedly.
– Because of the law of averages, accepting an actuarially unfair risk as a policy
is likely to produce inferior results over the long term.
2. Reframe by resetting reference points in order to accept losses and treat sunk costs as
sunk.
– Try using stock phrases such as “that’s water under the bridge” and “don’t cry
over spilled milk” as helpful reminders.
Summary
• Heuristics, biases, and framing effects impede managers from making the best use of
the traditional tools of corporate finance, causing them to make faulty decisions that
destroy value.
• Managers are inclined to choose negative net-present-value projects because they are
– excessively optimistic about the future prospects of their firms;
– overconfident about the risks they face;
– discount information that does not support their views; and
– exaggerate the extent of control they wield over final outcomes.
• Avoiding bias by means of corporate nudges is a major challenge that generally
requires a sophisticated, disciplined approach.
• Managers need to be aware of sentiment, psychological phenomena impacting
investors that can result in the mispricing of the securities issued by their firms.
– Mispricing raises issues about catering behavior and market timing.
