Behavioral and Social Corporate Finance

Abstract

Corporate finance is about understanding the determinants and consequences of the investment and financing policies of corporations. In a standard neoclassical profit maximization framework, rational agents, that is, managers, make corporate finance decisions on behalf of rational principals, that is, shareholders. Over the past two decades, there has been a rapidly growing interest in augmenting standard finance frameworks with novel insights from cognitive psychology, and more recently, social psychology and sociology. This emerging subfield in finance research has been dubbed behavioral corporate finance, which differentiates between rational and behavioral agents and principals. The presence of behavioral shareholders, that is, principals, may lead to market timing and catering behavior by rational managers. Such managers will opportunistically time the market and exploit mispricing by investing capital, issuing securities, or borrowing debt when costs of capital are low and shunning equity, divesting assets, repurchasing securities, and paying back debt when costs of capital are high. Rational managers will also incite mispricing, for example, cater to non-standard preferences of shareholders through earnings management or by transitioning their firms into an in-fashion category to boost the stock’s price. The interaction of behavioral managers, that is, agents, with rational shareholders can also lead to distortions in corporate decision making. For example, managers may perceive fundamental values differently and systematically diverge from optimal decisions. Several personal traits, for example, overconfidence or narcissism, and environmental factors, for example, fatal natural disasters, shape behavioral managers’ preferences and beliefs, short or long term. These factors may bias the value perception by managers and thus lead to inferior decision making. An extension of behavioral corporate finance is social corporate finance, where agents and principals do not make decisions in a vacuum but rather are embedded in a dynamic social environment. Since managers and shareholders take a social position within and across markets, social psychology and sociology can be useful to understand how social traits, states, and activities shape corporate decision making if an individual’s psychology is not directly observable.