Chapter 10

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Behavioral Corporate Finance

by Hersh Shefrin

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  !
 earning Objectives

1.Explain why excessive optimism and

overconfidence lead the managers of
acquiring firms to overpay, thereby
experiencing the winner¶s curse
—.Use the press coverage measure and
longholder measure to identify
executives who are prone to engage in
acquisitions

—
r. Explain why the managers of target firms who
are excessively optimistic, overconfident, and
trust market prices can destroy value for their
shareholders
4. Identify the manner in which being in the
domain of losses affects the decisions of
executives and board members in respect to
acquisition activity

r
 Traditional Approach

Î In the traditional approach, prices are

efficient.
Î Therefore, the market prices of both the
acquiring firm and the target firm coincide
with fundamental value, under the
assumption that both remain standalone
firms.
Î However, a merger between the acquiring
firm and the target firm holds the potential for
synergy.
4
 Synergy

Î In theory, the shareholders of the

acquiring firm will capture this synergy
through the acquisition of the target, by
paying the current market value for the
target.
Î Managers of the acquiring firm will only
go forward with the acquisition if the
value of the synergy is positive.
å
 Fungible Wealth
Stock or Cash
Since wealth is fungible and all assets
are priced correctly, the shareholders of
both firms will be indifferent to the
combination of cash and equity used to
finance the acquisition.

ü
 The Winner's Curse

Î When the winning bid in an auction

leads the winner to overpay, the winner
is said to experience the winner¶s curse.
Î Because overconfident managers suffer
from hubris, winner¶s curse in
acquisitions stemming from
overconfidence is known as the ³hubris
hypothesis.´
!
 M&A

Î A study by KPMG International of the seven

hundred largest acquisitions during the period
199ü through 199o found that over half
destroyed value.
Î Acquisition activity peaked at $1.o trillion in
—000, more than triple the level in the mid-
1990s.
Î Between 199å and —000, the average
acquisition price in the U.S. rose !0%, to $4!0
million.
o
 A Few arge osses

Î Between 1991 and —001, the shareholders of

acquiring firms lost $—1ü billion.
Î A disproportionate share of these losses can
be traced to very large losses by a few
acquirers during the period 199o through —001.
Î Many of the large loss acquirers had been
active acquirers prior to their large loss
acquisitions, and the market values of their
firms had been increasing.
9
 Behavioral Pitfalls:
Examples of Winner¶s Curse
Î In 1991, AT&T purchased computer firm NCR
for $!.ü billion.
Î Robert Allen was the CEO of AT&T from 19oo
through 199å, and oversaw AT&T¶s acquisition
of NCR.
Î The market¶s reaction to AT&T¶s acquisition
announcement was negative.
Î AT&T completed the deal, and its computer
operations subsequently lost $r billion over the
next r years.
10
 Overconfidence

Î On announcing AT&T¶s intention to

acquire NCR, Allen stated the following:
I am absolutely Y

 that together
AT&T and NCR will achieve a level of
growth and success that we could not
achieve separately. Ours will be a future
of promises fulfilled.

11

iacom

Î In 1994 media firm
iacom agreed to

purchase Paramount for $9.— billion.
Î By all accounts,
iacom overpaid for
Paramount by $— billion, despite
iacom
CEO Sumner Redstone¶s interests being
aligned with shareholders.
Redstone owned more than !å% of

iacom¶s cash flow and voting rights.
1—
 Cisco Systems

Î In 1999 Cisco Systems made its largest

acquisition.
Î It paid $ü.9 billion in stock for Cerent, Corp.
A small networking firm that had yet to show a profit,
was expecting to raise about $100 million in an IPO,
and had fewer than r00 employees.
Î Cisco shareholders exchanged r% of one of
the world¶s most valuable firms for a small
startup that had yet to show a profit.
1r
 WorldCom

Î WorldCom engaged in 1! acquisitions

using $r0 billion of debt.
Î In —00— it became largest firm to declare
bankruptcy in U.S. history.

14
 Intel

Î In —00—, the market concluded that $10 billion

of investments in the personal computer
business that Intel had made under its CEO
Craig Barrett had generated little value.
Î The firm¶s CFO Andy Bryant was quoted in
j



 as saying:
I don¶t know of anything that we purchased
that was worth what we paid for it.

1å
 Optimistic, Overconfident
Executives
Excessively optimistic, overconfident
CEOs are
1. described as such in the press, and
—. wait too long before exercising their
executive stock options.

1ü
 What the Evidence Shows

Î Firms whose executives qualify as excessively

optimistic and overconfident through press
coverage and on the longholder measure are
üå% more likely to have completed an
acquisition than firms whose executives do not
so qualify.
Î This tendency is compounded when the firm is
generating positive cash flow, but mitigated
when the board of directors has fewer than 1—
members.
1!
 Cash Flow

Î When firms are financially constrained,

excessively optimistic, overconfident
executives choose not to go to the
capital markets in order to secure the
funds needed to conduct an acquisition.
Î Instead they act as if the market
undervalues the equity and/or risky debt
issued by their firm.
1o
 Behavioral Pitfalls:
Overconfident CEOs
Î j



has used both
³optimistic´ and ³confident´ as adjectives
to describe Wayne Huizenga, the
founding CEO of Blockbuster
Entertainment Group.
Î There are many CEOs for whom such
attribution has not been made, such as J.
Willard Marriott, the CEO of Marriott
International.
19
Î During 14 years at the helm of Cook Data
Services, Wayne Huizenga conducted ü
acquisitions.
Î During the 1å years Willard Marriott was
at the helm of Marriott International, he
did not conduct a single acquisition.

—0

iacom and Blockbuster

Î Shortly after overpaying for Paramount,

iacom CEO Redstone merged
iacom with
Blockbuster.
Î Redstone told the press that he was
³confident´ about the Blockbuster deal and
stated that Huizenga, Blockbuster's chairman,
is ³as turned on as I am today by what we
have wrought.´
Î After the acquisition, Blockbuster turned out
to be a major financial disappointment for

iacom. —1
 Theory

Î Suppose that an acquiring firm is

considering the purchase of a target
firm.
Î The market value of the acquiring firm
is $— million and the market value of the
target firm, is $1 million, where both are
valued as standalone firms.

——
 Synergy

Î et there be $oå0,000 in synergy from

a merger of the two firms.
Î
alue of the combined firms is
$r,oå0,000
= $—,000,000 + $1,000,000 + $oå0,000

—r
 Efficient Prices

Î Prices are efficient, meaning that the

market prices of the firms, both pre- and
post-merger, coincide with fundamental
values.
Î Information is symmetric, meaning that
the managers of both the acquiring firm
and the target firm are equally well
informed.

—4
 Concept Preview Question
10.1
Put yourself in the position of the
manager of the acquiring firm.
1. What is the maximum amount you
should be willing to pay to acquire the
target firm?
—. If your firm is the only bidder, what is
the least amount you should expect to
pay in order to acquire the target firm?

—å
 Acquire if Synergy > 0

Î If the acquirer is the only firm bidding for

the target firm, and all managers are
rational, then the acquirer can obtain the
target by paying a hair more than the
market value $1,000,000.
Î In this case, the acquirer¶s managers will
do the shareholders of their firm a
service by acquiring the target as long as
the synergy value is greater than zero.
—ü
 AP

Î AP
= -premium + synergy + financing

side effects
Î In the example, the acquiring firm paid a
hair over the market value of the
acquirer, and so the premium was ~0.
Î In general, the guiding principle is to
make the acquisition if AP
D 0.

—!
 Cash or Stock

Î The acquirer might offer the shareholders of

the target firm a combination of cash and
shares in the combined entity.
Î These shares represent some fraction of the
value of the combined firm.
Î For example, the acquirer might offer the
target¶s shareholders $400,000 in cash
together with $ü00,000 in shares of the
combined firm.
—o

alue

Î With a cash payout to the target¶s

shareholders, rather than to the target
itself, the value of the combined firm
would fall by $400,000, the value of the
cash payout.
Î Therefore, the value of the combined firm
would fall to $r,4å0,000.

—9
 How It Ends Up

Î The fraction of $r,4å0,000 that the acquirer

offers the target¶s shareholders must equal
$ü00,000.
The fraction offered must be 1!.r9%
= $ü00,000 / $r,4å0,000
Î In this case, the shareholders of the target
firm end up with $1,000,000 in value,
($400,000 in cash and $ü00,000 in stock),
while the shareholders of the acquiring firm
end up with $—,oå0,000 (o—.ü1% of
$r,4å0,000).
r0
 Impact of Overconfidence

Î An overconfident manager will typically

overestimate the fundamental value of
both the acquiring firm¶s shares and the
amount of synergy in the merger.
Î Therefore, an excessively optimistic,
overconfident executive will typically
overpay for an acquisition.

r1
 Extending the Example

Î Suppose that the acquiring firm¶s managers

believe that their firm is worth $1,000,000
more than the market¶s judgment of
$—,000,000.
Î Suppose too that the acquiring firm¶s
managers overestimate the amount of
synergy by an amount $100,000.
Î How will the excessive optimism of the
acquiring firm¶s managers impact the criterion
they use to decide whether or not to proceed
with the merger? r—
 Conflicting Concerns

1. The acquiring firm¶s managers will worry

that because the target firm¶s shareholders
do not appreciate what the acquiring firm¶s
managers perceive to be the true value of
the acquirer, the target firm¶s shareholders
will demand too large a share of the
combined entity.
There may be little the acquiring managers can
do, except to accept that this will be part of the
price that they pay for acquiring the target.
rr
 Dilution Cost

Î Specifically, if the target firm¶s

shareholders receive the fraction
1!.r9% of the combined entity, then
the acquiring firm¶s managers
perceive them to be receiving an
additional $191,—90 that is
unwarranted.
Î Call this amount ³dilution cost.´
r4
 Second Concern

—. The acquiring firm¶s managers need to

decide whether the amount of synergy
that they perceive in the merger will
justify the price to be paid.

rå
 Behavioral AP

Î Components of behavioral AP
are:

premium
synergy
financing side effects including dilution cost
Î AP
= -premium + synergy + financing side
effects including dilution cost
Î In general, the guiding principle is to make the
acquisition if AP
D 0.

rü
 The Point

Î In formal, terms the acquiring firm¶s

overconfident managers will go through the
same kind of logic as their rational
counterparts.
Î However, instead of pursuing the merger as
long as the true synergy value is positive, they
will pursue the merger as long as the
perceived synergy ($9å0,000) exceeds the
dilution cost ($191,r04).
r!
 When Cash is Preferred

Î Rational managers of an acquiring firm do not

care about how payment is divided between
cash and stock.
Î Overconfident managers who represent the
interests of the acquiring firm¶s shareholders
will care.
Î By paying in cash, the acquiring firm¶s
managers perceive no dilution cost, whereas
when they pay in stock they do perceive there
to be a dilution cost.
ro
 Inefficient Prices and
Overvalued Acquirer
Î Suppose managers of the acquiring firm
perceive their firm to be overvalued.
Î In this case, the pecking order needs to
be reversed.
Î Now, the manager of the acquiring firm
would want to purchase the target firm
using overvalued equity in its own firm,
rather than cash.
r9
 Overconfident Acquirer and
Overconfident Target
Î If the target firm¶s managers are
overconfident, they will be prone to overvalue
their firm relative to the market.
Î In this case, they may require a premium
above the market value before being willing
to accept the acquiring firm¶s bid.
Î As will be seen in the examples below,
premiums are common and sometimes very
large.
40
 Asymmetric Information

Î A firm worth $— million consider acquiring a

target firm whose market value is $1 million.
Î Suppose that in confidential discussions, the
managers of the potential acquirer learn that
the target firm has developed a new
technology whose value is not reflected in its
current $1 million market capitalization.
Î The acquirer also learns that the new
technology would be the only basis for the
value of the combined firms to exceed $r
million. 41

alue of Technology

Î The target firm managers have done a

careful analysis to assess how much
the new technology is worth.
Î They have shared some information
with the managers of the acquiring firm,
enough for the latter to estimate that the
value of the new technology is
$oå0,000.
4—
 Partial Disclosure

Because the target managers have only

engaged in partial disclosure, the acquiring
firm¶s managers have established a value
range centered on $oå0,000.
The low end of the value range is $0
The high end of the value range is $1.! million
Any value in this range is as likely as any other

4r
 Concept Preview Question
10.—
The acquiring firm¶s managers typically make
value based decisions in a risk neutral
manner.
Risk neutral means that they do not require a
risk premium.
Put yourself in the position of a manager in
the acquiring firm.
What is the maximum price you would pay to
acquire the target firm?

44
 Winner's Curse

Î Suppose that the value of the new technology

were to be $å00,000, less than the $oå0,000
estimate.
Î In that case, the intrinsic value of their firm
would be $1.å million.
Î The target firm¶s board would be only too
happy to sell the firm for $rå0,000 more than
its intrinsic value.
Î In this situation, the acquiring firm would
overpay, thereby experiencing the winner¶s
curse. 4å
 The Point

Î Because the target firm will only accept

offers in which the acquiring firm
overpays, the acquiring firm should offer
no more than $1 million.
Î That is the lesson of the example:
assume the worst when the other party is
better informed.

4ü
 Images From
AO Time Warner

4!
 AO Time Warner

Î In January —000, the Internet service

provider America Online (AO )
announced its intention to acquire the
media conglomerate Time Warner.
Î The purchase price, $1üå billion in AO
stock, set an acquisition record.

4o
 Goal

Î The goal of merging of AO and Time

Warner was to create a distribution
channel whereby Time Warner¶s media
products would be delivered to millions of
consumers via Internet broadband.
Î Time Warner brought media products and
a television cable network to the
combination.

49

aluation

Î The merger of AO and Time Warner

occurred at the height of the technology
stock bubble.
Î Notably, the market¶s judgment of the
overall merger was favorable, with the
shareholders of Time Warner benefiting
at the expense of the shareholders of
AO .
å0
Î On the day of the announcement, the
value of the combined companies rose
by 11%, or $—!.å billion.
Î However, Time Warner stock increased
by r9% ($r— billion) while AO stock
declined by —.!% ($4.å billion).

å1
 Bubble Prices

Î In January —000, the market capitalization of

AO was $1oå.r billion, over twice as large as
the $or.! billion market capitalization of Time
Warner.
Î A similar statement applies to P/E, where
earnings are measured as EBITDA, earnings
before taxes, interest, depreciation and
amortization.
Î With the peak of the bubble not two months
away, was AO overvalued at the time?
å—
 The Key Questions

Î An opinion piece in º

magazine
suggests that AO could not have been priced
at intrinsic value in January —000.
Î AO ¶s CEO was Steve Case, and Time
Warner¶s CEO was Gerald evin.
Î Did Steve Case knowingly purchase Time-
Warner with overvalued stock?
Î And correspondingly, did Gerald evin and
Time Warner¶s shareholders trust market
prices?
år
 Steve Case

Î Case judged that dot-com stocks,

including the stock of AO , were
overpriced, and that he sought to exploit
the overpricing.
Î Moreover, he expected that Internet
stocks would collapse in the not too
distant future, and sought to protect AO
shareholders by acquiring a more mature
firm.
å4
 Case's Offer to evin

Î Case eventually offered 4å% of a

combined AO Time Warner to Time
Warner shareholders.
Î Under the terms of the deal, Gerald
evin would be chief executive of AO
Time Warner, while Steve Case would
be its chairman.

åå
 Gerald evin

Gerald evin trusted market prices.

During a press conference to announce
the merger evin stated:
Something profound is taking place. I
believe in the present valuations. Their
future cash flow is so significant, that is
how you justify it.

åü
 Ted Turner

Î Ted Turner, the creator of CNN, was a

major shareholder in Time Warner.
Î He owned 100 million shares that he
acquired through the sale of CNN to Time
Warner three years before, and held an
operating role overseeing his former
holdings.

å!
 Initial Reaction

Î Turner first opposed the merger of AO and

Time Warner, asking:
Î Why should I give up stock in a $—å billion
company for shares of this little p----ant
company?

åo
 Reversal Under Pressure

Î I had the honor and privilege of signing a

piece of paper that irrevocably cast a
vote of my 100 million shares for this
merger.
Î I did it with as much or more excitement
and enthusiasm as I did on that night
when I first made love some forty-two
years ago.

å9
 Asset Writedown

Î In April —00—, AO Time Warner wrote

down $å4 billion in goodwill, a charge to
its earnings that reflected the decline in
the value of the combined firm.
Î ooking back 1— months from the end of
the third quarter of —00—, the operating
profit for most of AO Time Warner
businesses experienced positive growth.

ü0
 AO

Î Publishing had grown by —ü%, networks

had grown by 1ü%, and the music had
grown by 10%.
Î However, AO ¶s operating earnings fell
by r0%.

ü1
  

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ü—
 Hubris

Î The adjective ³hubris´ has frequently been

applied to Steve Case in the press.
Î j


j
 did not paint a flattering
picture of the executives at Time Warner,
stating:
If Case was guilty of hubris, then the Time
Warner management team was guilty of
ignorance and credulity, industry analysts and
academics say.

ür
Images from H-P
and Compaq

ü4
 H-P and Compaq

Î In May —00—, H-P acquired Compaq

Computer in a takeover that featured
considerable drama.
Î In 1999, H-P was involved in three broad
business segments:
1. enterprise computing and services for
businesses
—. personal computers (PCs)
r. imaging and printing

üå
Î Board members and executives concurred that
that H-P¶s enterprise computing business was
losing the ability to respond effectively to
changing customer requirements, and that
regaining this ability required significant new
investment.
Î They also concurred that H-P¶s operating
margin on PCs was at best breakeven,
compared to a !% margin for industry leader
Dell Computer.
üü

iew From Boardroom

Î Imaging and printing was the H-P¶s most

profitable business.
Ink-jet and laser printers, and the steady revenue
stream from consumables produced 9r% of total
imaging operating profits and 11o% of overall
operating profits.
Î However, the board judged that remaining
competitive in imaging and printing required
continued investment for growth and tighter
linkages with enterprise information
technology.
ü!
Î One of the H-P board¶s primary goals
was to acquire a firm that would enable it
to confront industry leader IBM more
effectively.
Î In —001 IBM was gaining strength, as
was PC leader Dell Computer, whereas
H-P was losing momentum.

üo
 Domain of osses

Î H-P had missed its earnings target for

the fourth quarter of fiscal —000, and
subsequently provided guidance for
lower future earnings.
Î In this respect its managers were
operating in the domain of losses, at
least psychologically.

ü9
Î On July 19, —001, Fiorina raised the
merger issue with the other eight
members of H-P¶s board.
Î Only three expressed interest. H-P
director Sam Ginn raised doubts about
becoming more deeply involved in the
PC business.

!0
 Responding to Ginn

Î Ginn pointed out that both H-P¶s

computer business and Compaq¶s
computer business were not especially
profitable.
Î The consultants at McKinsey responded
to Ginn's concerns by saying that even a
small profit in PCs would translate into a
decent return on invested capital.

!1
 Responding to Dunn

Î Outside director Patricia Dunn took an outside

view.
Dunn was vice chair of Barclay¶s Global
Investors, H-P¶s third largest shareholder.
Î She noted that history has produced many
unsuccessful technology mergers and asked what
would make the odds of this one any better?
Î The consultants at McKinsey responded by citing
$—.å billion a year in cost savings, which led her to
feel more positively about a possible combination.

!—
 Three Questions
Posed by Fiorina
1. Do you think the information-technology
industry needs to consolidate and, if so, is it
better to be a consolidator or a consolidatee?
—. How important is it to our strategic goals to be
No. 1 or No. — in our chief product
categories?
r. Can we achieve our strategic goals without
something drastic?

!r
 Behavioral Issues

Î Did Carly Fiorina¶s questions appeal to

the directors¶ natural tendency to be
overconfident?
Î Did she frame the issue for them in a
way that placed them in the domain of
losses?
Î In speaking about drastic action, did she
induce them to be risk-seeking?

!4
 Morning After

Î Directors slept on these questions.

Î Sam Ginn indicated that his main goal
was to compete with IBM, and that
merging with Compaq would help.
Î Phil Condit, the then CEO of Boeing Co.
stated that although mergers are difficult,
focused acquirers are able to make them
successful.

!å
 Terms of Merger

Î In September —001, H-P and Compaq signed a

merger agreement.
Î Their joint press release indicated that the deal
would consist of a stock-for-stock merger
whereby one share of Compaq stock would be
equivalent to 0.ür—å of an H-P share.
Î The merged firm would have about $o! billion
in sales and 14å,000 employees.

!ü

aluation Table


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!o
Î Two years after the H-P/Compaq merger
closed, the printing unit contributed r0% of
H-P¶s revenue and o0% of its profit.
Î Some analysts actually assessed H-P¶s
printer business to be more valuable than the
firm as a whole.
Î Despite achieving the promised cost savings,
the merger failed to improve the firm¶s
competitive position in its other businesses.

!9
 Dismissal

Î In February —00å, j





characterized H-P¶s business services group
as second-tier, relative to industry leader IBM,
and noted that its computer division was losing
its battle against Dell.
Î That month, H-P¶s board dismissed Carly
Fiorina as CEO of H-P, and named
independent director Patricia Dunn as
nonexecutive chair.

o0
 Subsequent Scandal

Î H-P board member George Keyworth leaks to

the press about board discussions.
Î Carly Fiorina presses board to identify leaker.
Î OSS of trust on board
domain of losses.
Î Key issue for Patricia Dunn, who
Hires investigators who use unethical, illegal tactic,
pretexting.
Î At instigation of Tom Perkins, Dunn and 4
investigators are indicted by Bill ockyer.
Î Charges against Dunn dropped for reasons of
poor health.
o1
 Summary

Î The more optimistic and overconfident are

executives, the more they engage in
acquisitions, and the more they leave their
investors vulnerable to experiencing the
winner¶s curse.
Î In situations where the market price of a firm
roughly measures its intrinsic value,
excessively optimistic and overconfident
executives overestimate the synergy from
acquisitions, but believe their own firms to be
undervalued.
o—
Î As a result, these executives favor paying for
target firms using cash instead of stock.
Î Executives who are excessively optimistic and
overconfident according to press coverage and
the longholder criterion are especially prone to
engage in acquisitions, and prefer to pay in
cash instead of stock.
Î Moreover, they tend to discount the negative
market reaction to their acquisition
announcements.
or
Î Acquirers who always trust prices leave
themselves vulnerable to the winner¶s curse
during times when investors are irrationally
exuberant about target firms.
WorldCom¶s acquisitions serve as an example.
Î Targets who always trust prices, and accept
payment in the form of the acquirer¶s stock
leave themselves vulnerable to seller¶s
remorse, the flip side of the winner¶s curse.
Time Warner provides such an example.
o4
Î Managers who participate in acquisitions
often do so when they perceive
themselves to be operating in the domain
of losses.
H-P¶s acquisition of Compaq illustrates this
phenomenon.

oå