BEHAVIORAL FINANCE AND BUSINESS VALUATION 1

MID TERM EXAM

Prof. Sanjay Bakshi

Rahul Samaddar
19P104

Subject: BFBV1 Faculty: Prof. Sanjay Bakshi Roll No: 19P104

 Answer 1:
Key reasons for the poor profitability of the average Manhattan restaurant
according to the document “The Thrill of Losing Money by Investing in a
Manhattan Restaurant,” are as follows:

• An upscale area like Manhattan offers more scope of prospering with

respect to other areas, and hence everyone will try to enter the same
space leading to rise in competition. When competition increases
everyone gets a smaller slice of the total share and hence it leads to
poor profitability.

• People do not look at the actual number of restaurants that have

prospered out of the total number of restaurants that have opened up
in Manhattan. Also, the actual return of the investors needs to be
given a closer look at. Rather than being realistic, the average person
tends to be more opportunistic.

• Investors often throw in good money after bad money. So, normally
investors invest some more money in a poorly profitable business like
a Manhattan Restaurant hoping things to turn around instead of
pulling out of it.

The mental models that can be associated with this are as follows:

1. Herd Mentality: Inclination for individuals within a group to follow

along with what the group at large thinks or does. It is also known
as mob behavior, group mind, group think, crowd psychology. Since
everyone is opening up a restaurant at Manhattan to be profitable, I
will also do the same.

2. Availability Bias: The availability bias is the human tendency to think

that examples of things that come readily to mind are more

Subject: BFBV1 Faculty: Prof. Sanjay Bakshi Roll No: 19P104

 representative than is actually the case. Since I have witnessed only
few restaurants which are extremely profitable in Manhattan, I believe
that all the restaurants in Manhattan are profitable.

3. Confirmation Bias: Tendency to accept the first conclusion as the

solution to a problem and remain resistant to the search for any more
alternatives. Since I know Manhattan is an upscale area, I tend to
conclude that any hotel in the Manhattan area will prosper.

Subject: BFBV1 Faculty: Prof. Sanjay Bakshi Roll No: 19P104

 Answer 2:
The various reasons for these high switching costs are as below:

Aiming to own the entire value chain

YKK invested a lot of time and capital into making their operations close to
perfect in each part of the value chain which gave them a distinct
competitive advantage over competitors who would be affected by supply
chain issues and other challenges. A case-in-point was when the Japanese
earthquake struck and while other firms were severely impacted, YKK’s
operation was not hampered

Making superior products

YKK understood that a faulty zipper could render an entire expensive

garment unusable with the customers blaming the apparel manufacturer
even if it was the zipper which was faulty and thus YKK captured this niche
with making superior quality products. They designed their own customized
zipper machines since they felt the existing production methods weren’t up
to the mark and thus built a business moat.

Ensuring process consistency and effectiveness

They brought all stages of the zipper making process in-house including
smelting brass, concocting their own polyester, spinning and twisting their
own thread, dying, forging, molding zipper teeth etc. In addition, they even
make the boxes in which they ship their zippers. Also, they manufacture
their own zipper-manufacturing machines maintaining secrecy so that no
leaks can reach the competitors.

Subject: BFBV1 Faculty: Prof. Sanjay Bakshi Roll No: 19P104

 Answer 3:
Key events in South Sea bubble
The seeding of this bubble has started long before the bubble actually took
place, it started when Robert Harley in 1710 was made the chancellor of
the exchequer. At the time the government of Britain had a debt of
approximately 9 million pounds due to the various wars it was fighting with
many countries.
The bank of England was not easily financing the debt and hence Harley
had to switch to other means to finance it.
He brought in John Blunt to finance the debt. South Sea company was built
in support of Harley and run by Blunt to exchange the government debt
with the company’s share. To make the share lucrative, the shares also
had a monopoly attached to it for the owners. But the company was
practically built on nothing and had in fact no backing as the company was
sending to ports owned by Spain which was at war with Britain. After much
deliberation and a new king, a truce was reached wherein the South Sea
company could send 1 ship a year to the port. Hence the company was not
at all profitable and the only profit they could derive was through their
shares.
The company was exchanging the govt debts through the company’s share
which were driving up the prices and with further increase in prices,
whenever the prices dropped, Blunt convinced to invest again and sell it
later.
Soon this bubble had to burst when the confidence began to wane and the
price then plummeted.
Here, there is a clear evidence of social proof as there was a boom in
investments and investors ran to grab a share of the pie which became
very attractive in the eye of the investor

Subject: BFBV1 Faculty: Prof. Sanjay Bakshi Roll No: 19P104

 Key events in Tulipomania
In 1636, the entirety of Dutch society went crazy over exotic tulips which
was later called Tulipomania. The main factors which contributed to this
included:

Scarcity and High Demand

The Tulips were rare in the world, highly desired by the elite and fetched
very high prices. Very soon they became the object of trading since they
were believed to have high intrinsic value. This led to all classes of people
perceiving it as an investment vehicle and resulted in everyone including
nobles, citizens, mechanics, farmers, footmen, sailors, maid-servants etc.
dabbling in Tulip and looking to make a fortune.

Exchanges driving up prices to unsustainable levels

Tulip marts opened up where everyone would gather and trade in Tulips.
Stock jobbers saw this as an opportunity and drove up prices to
unsustainable levels to maximize their personal wealth at the expense of
others.
Too many people investing in the same instrument led to a rapid rise in the
valuations and human rationality went for a toss as investors paid high
sums of money to be a part of the bubble. When the market corrected itself,
the valuations came crashing down and investors lost huge sums of money
in now worthless assets.

Subject: BFBV1 Faculty: Prof. Sanjay Bakshi Roll No: 19P104

 Answer 4

DEFINITION:

Peltzman Effect is defined as the condition where post introduction of

certain policies or regulations the observed outcome is exactly opposite of
the expected outcome.

The Peltzman Effect is named after Sam Peltzman, a renowned professor

of economics at the University of Chicago Booth School of Business. In a
controversial research paper titled “The Effects of Automobile Safety
Regulation”, Peltzman argued that highway safety regulations were not
reducing highway deaths.

In Peltzman’s view, this was due to “risk compensation,” where drivers who
felt safer made riskier choices that canceled out the safety benefits. This
phenomenon was recognized as common, and the Peltzman Effect was
born.

EXAMPLES:

This theory can be applied to the case of introduction of fines for not
wearing seat belts in cars. Initially seat belts were introduced to decrease
the number of deaths due to road accidents. Traffic police also started
fining people who were not wearing a seat belt while driving. The intention
was to incentivize people from not paying the hefty fines and wear seat
belts which would in turn reduce the number of instances of deaths from
road accidents.

However, it was observed that instead of decreasing the number of

fatalities, the number of deaths increased post the introduction of fines.
Now people were wearing seat belts which made them feel safer while

Subject: BFBV1 Faculty: Prof. Sanjay Bakshi Roll No: 19P104

 driving. As a result, rash driving increased which eventually resulted in the
increase of deaths from road accidents.

This line of thinking is also applicable for the case of anti-lock brakes in
cars. Even though ABS is designed to increase vehicle safety by allowing
the vehicle to steer whilst braking. However, a number of studies show that
drivers of vehicles with ABS tend to drive faster, follow closer and brake
later, accounting for the failure of ABS to result in any measurable
improvement in road safety.

Subject: BFBV1 Faculty: Prof. Sanjay Bakshi Roll No: 19P104

 Answer 5:

Whenever a person faces new information related to an investment the

following things should be done by him:

• Free oneself from biases and take a bird’s eye view of the situation,
not having a tunnel vision regarding the situation.
• The person should think about the inter-relation between the
information present along with the existing information
• The odds which are there in a Bayes Theorem can be changed
because of the information and should be recalculated

Let’s imagine that you and a friend are playing your favorite board game.
Something your friend says leads you to make a friendly wager: that with
one roll of the die from the game, you will get a 6. Straight odds are 1/6, a
16% probability. But then suppose your friend rolls the die, quickly covers it
with her hand, and takes a peek. “I can tell you this much,” she says; “it’s
an even number.” Now you have new information and your odds change
dramatically to one in three, a 33% probability. While you are considering
whether to change your bet, your friend teasingly adds: “And it’s not a 4.”
With this additional bit of information, your odds have changed again, to
one in two, a 50 percent probability. With this very simple example, you
have performed a Bayesian analysis. Each new piece of information
affected the original probability, and that is Bayesian reasoning.

The big idea behind Bayes’ theorem is that we must continuously update
our probability estimates on an as-needed basis.

The same approach can be used in anything from an economic forecast to

a hand of poker, and while Bayes’ theorem can be a formal affair, Bayesian
reasoning also works as a rule of thumb.

Subject: BFBV1 Faculty: Prof. Sanjay Bakshi Roll No: 19P104

 We tend to either dismiss new evidence, or embrace it as though nothing
else matters. Bayesians try to weigh both the old hypothesis and the new
evidence in a sensible way.

Subject: BFBV1 Faculty: Prof. Sanjay Bakshi Roll No: 19P104