1) Managers of companies face three conflicting goals: maximizing value, share price, and taking advantage of mispricing. They may cater to irrational investor beliefs to boost share price through actions like changing investment strategies or payouts. 2) Evidence shows companies time stock issues and repurchases, and acquisitions using overvalued stock, to benefit at the expense of other shareholders. Managers and targets may agree to inefficient mergers due to short-term gains. 3) Studies found the proportion of dividend-paying firms fell from over 50% to below 20% from the 1970s-1990s partly due to company changes, but also dividend policy catering to investor preferences. Initiations and omissions

1. Chapter 15: Rational Managers and
Irrational Investors
Powerpoint Slides to accompany Behavioral
Finance: Psychology, Decision-making and Markets
by Lucy F. Ackert & Richard Deaves
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posted to a publicly available website, in whole or in part.
1

2. Mispricing and goals of managers
• Three conflicting goals in presence of potential
mispricing:
1. Maximize rationally-calculated present value of
future cashflows.
2. Maximize current share price relative to value.
– This goal can be pursued by undertaking various actions
which “cater” to a range of investor desires unrelated to
(rational) value-enhancement
2
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posted to a publicly available website, in whole or in part.

3. Mispricing and goals of managers cont.
• Examples of catering:
– Investors believe that certain kinds of investment (e.g., in
computer technology in late 90s) creates more value than
should really be the case.
– If certain investor groups with particular dividend
preferences (e.g., those desiring high, low, or no payout)
exist, and if not enough firms currently satisfy the desires
of these investor groups, catering may operate as firms
alter their dividend payout in response.
– Miscellaneous discrete actions:
• accounting changes
• earnings management
• name changes
3
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posted to a publicly available website, in whole or in part.

4. Mispricing and goals of
managers cont. ii.
3. Take advantage of current mispricing so as to
benefit current and holding shareholders.
• Done by issuing stock when it is overvalued
• Doing so benefits current shareholders at expense of
new shareholders
• This can be done to “pay for” hard assets in a merger
• Or buying stock back when it is undervalued
• Doing so benefits holding shareholders at expense of
selling shareholders
4
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posted to a publicly available website, in whole or in part.

5. Share issues and repurchases:
Evidence
• Evidence exists that firms time purchases and
sales of stock.
• Around the world, high issuance activity leads
to low future returns in 12 out of 13 major
markets.
• Using U.S. data from 1935-1972, five-year
returns that are below market returns by 21-
35% have been documented.
5
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posted to a publicly available website, in whole or in part.

6. Mergers and acquisitions:
Conventional theory
• It makes sense for even correctly priced firms to
combine when synergies exist, with both firms
sharing in the spoils.
• Firm A: Value = $200 million.
• Firm B: $100 million.
• Firm A+B = $400 million.
• A could acquire B paying $150 million.
6
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posted to a publicly available website, in whole or in part.

7. Stock acquisitions using overvalued stock
• Suppose a firm is overvalued by market.
• Further investors perceive that synergies can
be gained form a merger (though in reality
they do not truly exist).
• This can often explain stock acquisitions in
overheated markets.
• This can be true even if all managers (bidder
and firm to be acquired) understand this.
7
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posted to a publicly available website, in whole or in part.

8. Why would managers of acquired
firms go along?
1. Target managers may have short horizons.
– Since they plan to get out before the long run comes, their only
concern is the short run
– Managers who want to sell out (perhaps because they are nearing
retirement) would fit the bill
– Acquisition allows them to cash out overvalued equity
2. Target managers may expect to be paid for their
acquiescence.
– In form of acceleration in the exercise of stock options, generous
severance pay, or retaining management positions.
– Same incentive does not exist with cash acquisitions of undervalued
assets.
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posted to a publicly available website, in whole or in part.

9. Catering by changing company’s name
• Some companies changed their names to “dotcom”
names during internet craze of late 90s.
• Sample: 147 firms that changed their names in this
fashion from June 1998 to July 1998.
• Share prices appreciated after announcement (and
often dramatically so) – even when their underlying
business had little or nothing to do with internet.
• This dotcom effect on average led to average
cumulative excess returns of 74% during a 10-day
announcement window.
9
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posted to a publicly available website, in whole or in part.

10. Dividend policy and perfect markets
• In a world of perfect markets, dividend payout
should be irrelevant.
– Required: no taxes, transaction costs and information
asymmetries; hold constant firm’s financing and
investment policy
• Suppose that a firm currently pays out all of its free
cashflows in the form of a dividend, but it is now
considering eliminating its payout.
• Say investor actually desires 10% cashflow yield that
currently comes in form of dividend.
10
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posted to a publicly available website, in whole or in part.

11. Dividend policy and
perfect markets cont.
• She could employ process known as “home-made”
dividends.
• Done by selling off shares in lieu of receiving a cash
dividend and using the proceeds to “pay” herself an
amount of cash equivalent to the former dividend.
• Conversely, if an investor holds a dividend-paying
stock but does not desire cashflow, an automatic
dividend reinvestment program is answer.
11
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posted to a publicly available website, in whole or in part.

12. Dividend policy and perfect
markets cont. ii.
• Bottom line: investor “sets” own dividend yield.
• But real world is much more complicated than this.
• Frictions such as taxes and transaction costs exist.
• Because of these frictions managers accommodate
the dividend stability that investors seem to desire,
and only as a last resort cut dividends.
12
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posted to a publicly available website, in whole or in part.

13. Disappearing dividends
• Researchers, focusing on NYSE, AMEX, and NASDAQ
firms from 1972 to 1999, have documented that for
much of this period percentage of firms paying
dividends was on decline.
– In 1973 52.8% of publicly-traded non-financial non-utility firms
paid dividends
– Percentage rose until 1978 by which time it hit 66.5%, before
falling to 20.8% by 1999
• Is it because characteristics of firms changed, tilting
towards the characteristics that non-payers embody?
13
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14. Disappearing dividends cont.
• Conclude was that this was about half of explanation for
declining propensity to pay dividends.
• Larger, more profitable firms with fewer investment
opportunities tend to be payers, and it turned out that many
of the newly listed firms were smaller and less profitable with
an array of investment opportunities.
• Many of new listers in 70s tended to quite profitable:
– earnings of new lists averaged 17.8% of book value (vs. 13.7% for all
firms)
– earnings of new lists during 1993-98 averaged 2.1% (vs. 11.3% for all
firms)
14
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posted to a publicly available website, in whole or in part.

15. Is there a behavioral story?
• Catering motive may be best explanation.
• Evidence is based on time-variation in so-called
dividend premium.
• One way in which this premium can be proxied is by
difference between average market-to-book ratio of
dividend-payers and nonpayers.
• Then investigate whether dividend initiations and
omissions are related to time-variation in this
premium.
15
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posted to a publicly available website, in whole or in part.

16. Dividend premium and initiations
16
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posted to a publicly available website, in whole or in part.
Source: See Baker, M., and J. Wurgler, 2004, “Appearing and disappearing dividends,”
Journal of Financial Economics 73, 271-88.

17. Interpretation
• When dividend premium rises, reflecting
increased investor preference for dividends,
initiations tend to subsequently rise.
• On the other hand, when dividend premium
falls, reflecting decreased investor preference
for dividends, initiations tend to subsequently
fall.
17
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posted to a publicly available website, in whole or in part.

18. Four distinct payout periods
• Going back in time there are four distinct trends:
1. Increasing trend in the mid 1960s
2. Decline falling into negative territory through 1969
3. Positive trend in 1970 staying in positive territory till 1977
4. Well-known “disappearing dividends” period after that
• Each of these trends lines up with a corresponding
fluctuation in dividend premium.
18
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posted to a publicly available website, in whole or in part.