Volume 7, Issue 10, October – 2022 International Journal of Innovative Science and Research Technology

ISSN No:-2456-2165

Behavioral Corporate Finance : A Brief Review

Mehdi ALHIANE Khadija ANGADE (Ph.D.)
Laboratory MAPES, ENCG Agadir Laboratory MAPES, ENCG Agadir
Ibn Zohr University Ibn Zohr University
Morocco Morocco

Abstract:- Traditional corporate finance focuses more on II. APPLIYING BIASES, HEURISTICS AND
what business leaders are supposed to do than what they FRAMING EFFECTS TO FINANCIAL
do now. Behavioral approach is designed to examine DECISIONS
what they actually do, why they do it, and make
suggestions on how they could do their jobs better. The A. Biases and Heuristics
main goal of this brief review is to understand These are specific psychological phenomena,
psychological phenomena related to business behavior intrinsically linked to the way our brain works. To be able to
problems and how they affect financial decisions. Indeed, dissect them from our cognitive vortex, psychologists [1]
these phenomena involve general human characteristics, have suggested categorizing the functioning of the human
they affect managers and investors. So, managers need to brain into two main groups:
understand how these phenomena affect their own  The intuitive brain called System I
judgments and decisions; however, they also need to  The deliberative brain called System II
understand the decisions of other managers, as well as
the decisions of the investing public whose trading These two systems constitute the so-called theory in
activities determine market prices. psychology: “Dual System” [2].

Keywords:- Corporate Finance, Behavioral Finance, Naturally, the intuitive System I shows performance
Traditional Finance, Psychological phenomena, Brief that is sometimes surprising and abrupt, due to the absence of
review. a long time of cognitive computation. So, he is more prone to
error, reckless and impulsive.
I. INTRODUCTION
The System II often seems to choose to make thoughtful
Behaviorism in finance deals with the mechanisms and balanced decisions. That said, it is not always easy to
affecting people's choices and judgments. These mechanisms have the necessary mental resources to perfectly compile
are categorized into two groups: such an intellectual load.
 Biases & heuristics; and
 Framing effects. Applied to finance, this Dual System theory embodies
all the difference that exists between classical finance and
The foundation of the behaviorism in finance is behaviorist finance [3]. The classical one advocates all
implementation of research on decision-making by the System II principles, such as the rationality of individuals and
financial manager, and the practice of this perilous decision- the efficiency of markets. On the other side, behavioral
making process. This leads suggesting that the imperfections finance adds a new explanatory strain of decisions in finance,
of business decisions are intensively linked to the for instance the mechanisms of the intuitive brain.
psychological vulnerabilities of human.
Thus, the study of System I aims to help managers make
Beyond the simple understanding of the psychology of better decisions, by becoming aware of the main
the leader, the study of behaviorism in finance aims to create psychological and heuristic biases which, obviously, are
value by transmuting human-psychological vulnerabilities omnipresent in all decision-making processes.
into financial levers.
 Description of Biases and Heuristics
So, this review studies how biases combined with The main psychological biases are [4]:
mental shortcuts (heuristics), often considered by the subject
as a removable rule, influence the Gains/Loss equation of  Over-optimism
companies. Otherwise, this article draws an analogy between Individuals tend to overestimate the probability of
traditional finance and behavioral finance based on major having positive outcomes and underestimate the probability
topics in corporate finance. of having negative ones.

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Volume 7, Issue 10, October – 2022 International Journal of Innovative Science and Research Technology
ISSN No:-2456-2165
 Overconfidence  Availability
Individuals tend to be overconfident in their level of Individuals first focus on previously available
intellectual knowledge (without necessarily being unaware or information to make decisions; it can be experience,
incompetent). These individuals often identify themselves memories, …etc.
with being above average people.
 Anchoring
 Confirmation bias Individuals remain stuck on ideas, figures or judgments
Individuals often spend more time seeking information and carry out adjustments based on additional information
that supports their own positions, and sometimes “force” an received.
executive committee to converge on that position.
 Affection
 Control illusion Decision-making is fundamentally linked to intuition,
People overestimate the control they have over events instinct, and mindset.
and transitively over desired results.
 Interaction phenomenon
Otherwise, the main heuristics are [4]: It is an amplifying phenomenon that assumes the
 Representativeness & Conjunction Error existence of a bias or heuristic can have a cause-and-effect
In this case, decision making is dependent on heuristics relationship on other biases or heuristics. The coexistence and
relying on analogies and stereotypes. Representative thinking interaction of these can create an amplifying effect on the
generates systematic errors called: Conjunction error. individual action/reaction.

 Appliying Biases and Heuristics to financial decisions

The illustration of the biases and heuristics’ effect on
financial decisions [5] is presented in the table below:

Biases & Heuristics Items Effect on Financial Decisions

Neglecting cost reductions during a recession.
Over-optimism
Significant impact on profit for the year.
Making acquisitions with fragile fundamentals.
Overconfidence Reduction in the company value because of the poor
performance of these investments.
Biases
Ignoring information from recognized sources that are
Confirmation bias opposite to the manager's point of view.
Significant impact on profit for the year.
Overestimating the degree of risk control.
Control illusion
Significant impact on profit for the year.
Representativeness & Conjunction Choosing the wrong project based on poor forecasts.
Error Reduction in the value of the company.
Choosing the wrong project based on poor forecasts.
Availibility
Reduction in the value of the company.
Heuristics Staying fixed on a number by making insufficient
Anchoring adjustments.
Reduction in the value of the company.
Rely on intuition instead of financial analysis.
Affection
Reduction in the value of the company.
Table 1:- effect of biases and heuristics on financial decisions

B. Framing Effects  Description of Framing Effects

The framing effect refers to the way in which  Basic Theories
individuals are influenced by the environment and the context  Risk Aversion [7]
of the decision-making process [6]. The way of Individuals are risk averse when it comes to significant
describing/presenting a problem alone can influence the potential gains. However, they show a preference for risk
approach that an individual will adopt during his reflection when considering a loss.
and will naturally arouse one or more psychological
mechanisms. The framing effect is indeed made up of several  Fourfold Risk Pattern [8]
theories, intimately intertwined, founding behavioral finance. Contrary to risk aversion which suggests two possible
Developed mainly by Kahneman and Tversky, it is scenarios (absolute gain or absolute loss), the Fourfold Risk
considered the basis of the famous prospect theory [2]. Pattern (FRP) highlights four scenarios describing an
individual's likely attitudes to risk: (1) risk seeking on low
probability gains, (2) risk aversion to high probability gains,

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 Volume 7, Issue 10, October – 2022 International Journal of Innovative Science and Research Technology
ISSN No:-2456-2165
(3) risk aversion to low probability losses, and (4) risk several specificities. That said, natural reference points are
seeking on high probability losses. distinguished, such as zero in most financial performance
indicators. However, it does not prevent individuals from
 Related Theories aspiring to several other reference points: this is called the SP/
 Prospect Theory [2] A (security, wealth/success). SP/A theory interprets “fear &
Unlike utility theory [9] which assumes that individuals hope” emotions and their impact on decisions.
are rational and make choices that provide them maximum
utility, prospect theory incorporates the mental sensation  March-Shapira Framework [11]
linked to anticipations of gains and losses. Thus, individuals Applying SP/A theory, the March-Shapira Model
fix their choice according to a reference point, which is assumes that a firm in “desperation” takes substantially low
subjective and personal. It means that the perception of gains risk. The curve reverses once the financial situation begins to
and losses differs from one individual to another and does not improve as well as his “hope”.
systematically imply rational behavior.
 Debiasing [12]
 Narrow/Broadly Framing “Debiasing” or mitigating errors is one of the purposes
In the continuity of prospect theory [2], the way in of studies in behavioral finance. This is a set of major
which the individual frames a risk, substantially impacts interventions, such as corporate culture strategies, and minor
decision-making. Two ways are naturally distinguished: ones, so-called “Nudges”.
Narrow Framing, which deals with the risks one by one; and
Broadly Framing which treats risks as a single whole.  Nudge [13]
The "Nudge" can indirectly influence individuals in
 Aspiration Point & SP/A Theory [10] their economic choices.
The reference point constitutes both the innovation and
the limit of prospect theory. Determining a common  Appliying Framing Effects to financial decisions
reference point is practically impossible since it results from The Table 2 presents the basic theories’ effect of
framing effects on financial decisions [14]:

Framing Effects Influence on financial decisions

Granting debt at high rates, in a context that anticipates a drop in rates. As a result
Risk Aversion of the decline, the company no longer grants debt.
Shortfall in low-cost growth. Forgo the tax savings due to finance charges.
Investing in markets with a high probability of losses and consequent gains, as
binary options market.
Fourfold Risk Pattern
Reduce the value of the company by impacting the quality of the assets held,
and the losses generated by them.
Table 2:- Influence of framing effects on financial decisions

III. THE BEHAVIORAL APPROACH AND MAJOR The valuation methods emanate from a flawless
TOPICS IN CORPORATE FINANCE compendium of classical financial theory; made up of
sophisticated formulas and great mathematical and
After highlighting the main indicators of behavioral accounting rigor [16]. However, in practice, the valuation of
finance (biases & heuristics and framing effects), this review capital highlights the use of heuristics and demonstrates a
draws an analogy between traditional finance and behavioral particular vulnerability to the biases of individuals
finance from the point of view of company valuation undertaking valuation work.
methods, capital structure, dividend policy, agency conflicts
and corporate governance, mergers and acquisitions, and On the one hand, comparable methods based on
group financial management. formulas that are true by definition (tautology), are ultimately
based on the judgments of analysts on the similarities that a
A. Company Valuations group of companies would have with the one they are trying
Typically, there are two main valuation approaches in to value [15]. Also, the choice of ratios to be able to make this
traditional finance [15]: 1) valuation by intrinsic value (like comparison is even more intuitive and emotional for analysts.
the DCF) and 2) valuation by comparables (like the P/E ratio). The terms of these ratios undoubtedly depend on the
These methods are often combined and weighted by analysts judgments of analysts, i.e.: P/E and dependence on the
and CFOs. estimate of future results [17].

As it is known, valuing a company is primarily a first On the other hand, intrinsic methods do not escape this
step in setting its price or determining a reference point at the “human” nature. The estimation of future financial flows is
target price [15]. That said, in mergers and acquisitions, the obviously the victim of overvaluations or undervaluations
price is certainly a long negotiation process, the valuation of due to biased assumptions [17]. Several case studies [18] are
which is only one argument among others. made and will have to be conducted more to identify the
impact of biases and heuristics on the growth assumptions in

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Volume 7, Issue 10, October – 2022 International Journal of Innovative Science and Research Technology
ISSN No:-2456-2165
the intrinsic valuation models, i.e.: the case of high-tech In practice, managers are constantly in a dilemma
companies in the early 2000s (Ebay [19], Amazon, Apple, forcing them to balance between the long-term value of the
Microsoft, … etc.). company and its short-term value [21]. It goes without saying
that deciding to maximize one value does not always mean
B. Capital Structure maximizing the other value.
The capital structure is a concept closely linked to the
two major decisions of a company: 1) the financing decision The BPV is a combination of the long-term (VL) and
and 2) the investment decision [20]. The first aims to restore short-term (VS) values of the company, it is written
balance and financial fundamentals, the second aims above BPV = VL + aVS, “a” being a non-negative weighting giving
all to maximize the asset present value. rise to the importance of the short-term value [20]. Thus, the
decision (of financing or investment) of managers must
The traditional approach adopts two main assumptions: assess its impact on the two values of a company [22]. In
1) the rationality of managers and 2) the efficiency of practice, it is very rare to find managers who maintain a
markets. In contrast, the behaviorist approach mitigates these balance between the two values [23].
two assumptions: managers are humanly imperfect and
vulnerable to psychological pitfalls [20]. Also, market prices  How do managers decide on the capital structure in
often deviate from their fundamental value in the most practice?
efficient markets, or at least they are on paper. The behavioral approach of capital structure suggests
that firms with overly optimistic and overconfident managers
 BPV: Behavioral Asset Present Value use more financial leverage, invest more than other firms, and
This is an important theory in behavioral economics in their investment policies exhibit excessive sensitivity to cash
general. Originally developed by economists Malcom Baker flow [24].
and Jeffrey Wurgler [20], the BPV is a critique of the classic
APV model that places importance on the point value of Under certain circumstances, framing effects can
society. operate in the opposite direction and prevent some firms from
fully exploiting their debt capacity [25].

Decision Discussion
Managers tend to issue new shares when the stock market is overvalued. However,
Capital increase: Market timing
the dilution of the capital and thus of the earnings per share is the more decisive.
It goes without saying that debt hinders the flexibility of managers to take
advantage of new opportunities and hence to be able to take on more debt.
Debt and financial flexibility
Debt market timing allows managers to choose periods of low interest rates or
attractive risk profiles to best maintain the company's flexibility.
Targeting an optimal level of this ratio has already been long discussed in classical
Debt/CP ratio theory. From a behavioral perspective, managers tend to have personal aspiration
points reinforced by biases of overconfidence or overoptimization, … etc.
In practice, managers seem not to respect this pecking order. The choice of
Pecking order financing among others depends a lot on the evolution of the company’s value and
its market.
Table 3:- Capital Structure Decisions Practice

C. Dividend Policy These heuristics involve smoothing dividends per share

Dividend and redemption policies are linked to framing around salient and memorable numerical values.
effects. In the traditional Modigliani and Millier approach
[26], people are assumed to be insensitive to framing effects. By following these heuristics, managers send important
In the behavioral approach, mental accounting and framing signals to stock markets [29]. However, behavioral signal is
effects lead individual investors, who consider dividends as different from traditional signal, which aims first and
attractive, to develop a heuristic that dividends are a foremost to stand out from competitors, but above all to
necessity, and their absence inevitably becomes penalizing reassure the investor who sees in it a yield value, or even a
[27]. safe-haven in his portfolio [29].

Older and retired investors find dividends attractive Prices are impacted by changes in dividend policy and
because they regard dividends as a replacement for wages and share buybacks. Share buybacks don't need to be regular,
salaries. Young salaried investors find dividends attractive whereas dividend payouts entail much more a commitment to
because regular dividends make it easier for them to tolerate regularity [30]. Many of these impacts lead to price
stock market risk. distortions, including drift effects. Markets react to both
dividend omissions and dividend payouts, and the strength of
Concerning dividend policy, psychological phenomena the price impact is twice as great in the case of omissions [28].
matter particularly [28]. Indeed, managers have developed a
heuristic to respond to the psychological needs of investors.

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Volume 7, Issue 10, October – 2022 International Journal of Innovative Science and Research Technology
ISSN No:-2456-2165
D. Agency Conflicts and Corporate Governance A long-time holder is an executive who holds his call
Incentive compensation is at the heart of good corporate options until very near expiration. Executives who are overly
governance [31]. In this regard, a company's board of optimistic and overconfident are particularly prone to engage
directors must ensure that executive compensation is in acquisitions and prefer to pay in cash rather than stock [37].
sufficient to attract and retain talented managers, that Also, they tend to brush off the negative market reaction to
compensation plans serve to align the interests of managers their acquisition announcements, instead of pursuing what the
with those of shareholders and that managers are not market deems to be bad acquisitions.
overpaid.
Acquirers who always trust prices make themselves
In practice, empirical evidence indicates that executive vulnerable to the winner's curse at times when investors are
compensation has too little variability in performance pay, irrationally exuberant about target companies [39]. The
under-dismissal, and over-payment for executives [32]. acquisitions of WorldCom are an example of this. Targets
Directors' comments reveal that corporate board members that still trust prices and accept payment in the form of stock
have been overconfident in their ability to structure incentives from the acquirer make themselves vulnerable to seller's
appropriately without overpaying senior executives. remorse stemming from restoration (the flip side of the
Administrators also suggest that their tasks are made more winner's curse). Time Warner provides another example.
difficult by the executives’ overconfidence [32]. Business leaders who participate in acquisitions often do so
when they perceive themselves to be operating in the realm
In traditional theory, employee stock options are used to of losses.
align the risk attitudes of managers and shareholders [33].
Indeed, according to the traditional approach, the inability of The acquisition of Compaq by HP illustrates this
managers to diversify their portfolios, as well as shareholders, phenomenon [40]. Indeed, the HP–Compaq example serves
leads them to be more risk averse than shareholders. to illustrate the psychological phenomena that guide the
thinking of managers and directors. However, executives
However, managers who behave in accordance with don't need to think of themselves as being in the losing streak
prospect theory, might find the risk characteristics of to make acquisitions that increase risk [40]. CEOs, who are
attractive call options due to their casino effect [34]. In this younger than average and hold below-average positions, are
regard, stock options could also induce risk-seeking behavior prone to making risky acquisitions, especially if they seek
due to the tendency to overweight low probabilities [31]. thrills in other ways, such as flying private jets.

Moreover, companies seem to pay options to their Valuation is subjective, and for this reason, leaders rely
employees when they are inclined to overvalue these options. on heuristics that exhibit psychological phenomena such as
The combination of aspirational risk-taking and anchoring to recent stock price highs, particularly the 52-
overconfidence can also induce ambitious and unethical week high [38].
managers to manipulate accounting information, to exercise
their stock options when the stock is too expensive [34]. F. Group financial management
Group financial management combines finance and
With this aim in mind, a combination of behavioral business management, focusing on how people work together
phenomena and agency conflicts has affected some in groups to make financial decisions and judgments [41].
accounting firms [35]. These events were the catalyst for the Valuation and risk assessment are examples of corporate
passage of the Sarbanes-Oxley Act. Similarly, the global financial judgments. Budgeting, merger and acquisition
financial crisis was the catalyst for the passage of the Dodd- activities, capital structure and bonus plans are, in turn,
Frank Act, with its “say on pay” provision [34]. business decisions.

The combination of regulatory changes and real events In addition, business processes, and more broadly the
appears to have dampened the growth of performance-based corporate culture, define the environment and the framework
compensation measures, shifting from stock options to in which these judgments and decisions are made [42]. On
restricted stocks [36]. that point, financial management is not just a piecemeal set
of skills for making judgments and decisions about the
E. Mergers and Acquisitions individual elements that make up corporate finance. But it is
Generally, the more optimistic and overconfident also an integrated approach that focuses on the human
managers are, the more they engage in acquisitions and the elements that underlie these group processes [41]. Identifying
more they leave their investors vulnerable to the winner's process losses and the lessons to be learned to mitigate them
curse [37]. is at the heart of how lessons learned from behavioral
corporate finance can increase value [43].
In situations where a company's market value roughly
measures its intrinsic value, overly optimistic and In theory, the group process adds synergistic value to
overconfident leaders overestimate the synergy of the efforts of individual group participants [43]. In practice,
acquisitions but believe their own companies are undervalued three factors lead this synergy to be less than maximum, and
[38]. As a result, these executives prefer to pay for target sometimes negative [44]. First, although synergy is positive
companies using cash instead of stock. for intellectual tasks, it is generally negative for judgmental

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Volume 7, Issue 10, October – 2022 International Journal of Innovative Science and Research Technology
ISSN No:-2456-2165
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