Chapter17 judgmentalbehavioural
- 1. CHAPTER 17 JUDGMENTAL, BEHAVIOURAL, STRATEGIC AND ORGANISATIONAL CONSIDERATIONS
- 2. OUTLINE • Managerial intuition and judgment • Mission, strategy and capital budgeting • Bridging the gulf between strategic planning and financial analysis • Informational asymmetry and capital budgeting • Organisational considerations • Reverse financial engineering • Group process • Impact on earnings
- 3. Managerial Intuition and Judgment Many chief executives admit that ultimately their decisions are based on gut-feeling. Robert Docktor conducted an experiment in which he wired up a group of chief executive officers to an electroencephalograph. He found that the brains of chief executive officers were more active in right hemispheres, suggesting that they frequently relied on intuitive hunches to define complex problems in an open-ended state of ambiguity. Henry Mintzberg’s study likewise showed that for making most of the strategic decisions managers depend on the factor of judgment rather than explicit analysis. They are often guided by their intuition and are not able to explain adequately the how or why of their strategic decisions.
- 4. Factors Influencing Judgment Judgment is influenced by a variety of factors such as : Quality of information Track record of the sponsor Internal politics Intangible benefits Opportunity cost Cost of reversing the decisions Superstition
- 5. Superstition Astrologers and psychologists have argued that magical rites and superstitious behaviour make the world look more deterministic and instil confidence in our ability to manage it. Superstitious beliefs seem to help in: Relieving anxiety Imparting a sense of control Encouraging necessary activity Hence, such beliefs persist. And the more unpredictable or uncertain the future appears to be, the greater may be the psychological urge to rely on superstitions.
- 6. Mission The mission of a firm provides the overarching perspective for its activities which naturally cover strategy formulation and capital budgeting. Most firms state their mission in formal terms. Here are some examples of mission statements. Merck : To preserve and improve life IBM : To achieve value-added leadership position Mckinsey : To help leading corporations and governments to be more successful. Ranbaxy : To be a research-oriented international pharmaceutical company. HDFC : To develop close relationships with individual households; maintain position as the premier housing finance institution in the country; transform ideas into viable and creative solutions.
- 7. Business planning Capital budgeting April- Several scenarios are explored August September Initial premises are agreed to September Initial capital budgeting guidelines are formulated October - Work is continued toward October - Capital budget selection December developing a final formal January is carried out in divisions business plan and departments January Final business plan is adopted February Capital budget is approved by the executive committee March Capital budget is approved by the board Linkages between Business Planning and Capital Budgeting
- 8. An Approach to Decision Making Consistency with Strategy? Accept Positive NPV? Reject Significant Intangibles? Yes Yes Yes No No The key guidelines underlying the approach displayed above are : In a decision involving measurement as well as judgment, as far as possible, separate the quantifiable and intangible factors. Don’t rely exclusively on measurable factors and spurious over- quantification. Put differently, avoid the ‘what counts counts’bias.
- 9. Strategic Planning and Financial Analysis Strategic planning Financial analysis Objective Achieve a balanced goal structure Maximise shareholder value Responsibility - Internal Corporate planning department Finance department - External Consultant Investment banker Type of analysis Primary qualitative Primarily quantitative Advantage Comprehensive qualitative Disciplined quantitative assessment reasoning Disadvantage Lacking in rigour Omission of hard-to- quantify factors
- 10. Mistakes Committed in Financial Analysis In applying DCF analysis, the following mistakes are commonly committed: • Mechanical projection of cash flows • Optimistic bias in cash flows • Emphasis on IRR • Inconsistent treatment of inflation • Unreasonably high discount rates • Omission of embedded real options
- 11. Financial Naiveté' of Strategic Planning Strategic planning is often naïve from the financial point of view. Wit the following: Strategic analysis focuses on variables like earnings per share and book rate of return which are considered irrelevant by modern finance theory. Strategic planning is sometimes based on the premise that a firm should, by and large, depend on internally available funds. Put differently, the existence of the capital market is ignored. The hurdle rates applied in strategic planning are often not related to the opportunity cost of capital. Strategic planning typically emphasises a diversified business portfolio when finance theory suggests that investors can resort to more efficient “home made” diversification.
- 12. Reconciling the Differences To bridge the gap between strategic planning and financial analysis, a conscious effort is required on both the sides. Financial analysts must avoid the mistakes commonly committed by them and expand the scope of their work to reflect the values of options embedded in investments of strategic significance. Strategic planners must understand the logic of DCF analysis, acquire familiarity with the meaning of capital market data, and calculate the NPVs, at least as a rough check on the results of their analysis. While a complete reconciliation is not practical, a sincere attempt to see each other’s point of view and to unearth hidden premises will facilitate better communication and understanding. This will ensure that strategic analysis is not financially naïve and financial analysis is not insensitive to strategic issues.
- 13. Informational Asymmetry and Capital Budgeting The conventional ‘text book’ approach to capital budgeting is starkly simple : accept projects which have a positive NPV. It does not make any difference whether the investment decision making is centralised or decentralised; it is irrelevant whether the existing firm implements it or a newly set up firm executes it; it does not matter what mix of financing is employed. The behaviour of firms, however, is not always in conformity with what has been said above. In the real world : Firms often ration capital and do not invest in all projects that have positive NPVs. A lot of attention is paid to the extent to which capital budgeting decisions are centralised. Often, new projects are organised as separate corporate entities. The mix of financing is considered to be very important.
- 14. Why does a discrepancy exist between what the conventional model says and how the real world firms behave ? Informational asymmetries of various sorts seem to create such a hiatus. Informational asymmetry exists if the transacting parties have unequal information, ex ante or ex post. We may classify informational asymmetry into three broad types : · Informational asymmetry between shareholders and bondholders · Informational asymmetry between current shareholders and prospective shareholders · Informational asymmetry between managers and shareholders
- 15. Informational Asymmetry between Shareholders and Bondholders Informational asymmetry between shareholders and bondholders has two possible distorting consequences Asset substitution moral : Shareholders may prod hazard management to substitute riskier assets for safer assets, at the expense of bondholders Underinvestment moral : In firms with risky debt, hazard shareholders have an incentive to avoid investing in new projects that have a positive NPV, because they would not like the cash flows of new projects to be diverted for servicing existing risky debt.
- 16. Informational Asymmetry between Current Shareholders and Prospective Shareholders When there is informational asymmetry between current shareholders and prospective shareholders, the latter will not fully appreciate the future payoffs of various resources commitments. The common distortions resulting from such informational asymmetry are : Preference for projects with shorter payback period. · A greater degree of capital rationing. · Centralisation of capital budgeting. . Accumulation of liquidity despite the existence of positive NPV projects.
- 17. Informational Asymmetry between Managers and Shareholders Thanks to their informational advantage, managers enjoy latitude to choose investments aimed at building their reputation, rather than enhancing shareholders wealth. The concern for managerial reputation may lead to three kinds of distortions in investment decisions: Visibility Bias Managers seek to improve short term indicators of performance. Resolution Preference Managers attempt to advance the arrival of good news and delay the announcement of bad news. Mimicry and Avoidance Managers try to imitate the actions of superior managers and avoid the actions of inferior managers.
- 18. Squeezing of an investment to improve short term cash flows Premature liquidation of assets to show that they are worth a lot. Adoption of projects with earlier payoffs. Avoidance of worthwhile projects that carry risk of early failure to protect short-term reputation. Escalation of inferior projects to avoid admission of failure Undertaking projects which are supposed to have benefits in distant future to protect short-term reputation. Conformity with other managers to avoid the ‘odd manager’ label. Deviation from other managers to avoid seeming mediocre. These incentives may lead to the following investment biases:
- 19. Reverse Financial Engineering Many organisations have reasonably well-defined quantitative indicators (such as IRR > 20 percent) for approving projects. Since a project sponsor is keen to get his project included in the capital budget, he is likely to massage the numbers and dress up his project proposal.
- 20. Mitigating Financial Manipulation McGrath and MacMillan have suggested a process they call discovery- driven planning that has the potential of improving the quality of analysis. It reverses the sequence of the steps in the stage-gate process. In traditional method: Assumptions Financial Projections Discovery-driven planning starts with the minimal acceptable revenue, income, and cash flow statement and then asks: “What assumptions must be fulfilled to get these numbers?” McGrath and MacMillan refer to this as “reverse income statement.” The traditional method focuses the spotlight on financial projections, while obfuscating the assumptions. By contrast, discovery-driven planning focuses the spotlight on the assumptions that reflect the key uncertainties.
- 21. Group Process In theory, a group decision is supposed to exploit the synergies arising from bringing together people with diverse skills, perspectives, and values. Many groups are unable to achieve process gains due to the following: In intellectual tasks groups tend to outperform individuals whereas in judgmental tasks groups tend to under perform individuals. Groups tend to become polarised in respect of risk tolerance. As a result of group discussion, group members tend to readily accept a decision.
- 22. Reasons for Group Errors Groupthink Like individuals, group are characterised by a collective form of confirmation bias called groupthink. Poor Information Sharing. Inadequate Motivation.
- 23. Countering Groupthink According to Hersh Shefrin groupthink can be checked by: Asking group members to refrain from stating their positions at the beginning of the discussion. Explicitly encouraging debate, disagreement, and information sharing. Designating one member of the group to be a devil’s advocate for each major proposal. Regularly inviting outside experts to attend meetings, with the charge that they challenge the group to refrain from meek conformism.
- 24. Impact on Earnings In theory, managers are supposed to maximise firm value by choosing projects on the basis of their NPVs. In practice, managers look at NPVs as well as the accounting implications of their decisions. In particular, they are concerned with the impact of investments on reported earnings in the short run.
- 25. Reasons and Consequences of Emphasis on Short-term Earnings Reasons for Emphasis on Short-term Earnings. Short-term incentive compensation of top management is often linked to earnings. Value of stock options and stock grants depends on corporate earnings, at least in the short run. When reported earnings are good, top managers enjoy greater freedom. Favourable earnings inspire greater confidence in all stakeholders. The emphasis on short-term earnings may lead to acceptance of projects that are earnings-accretive but NPV-negative.
- 26. SUMMARY A mosaic of influences that can be described qualitatively have an important bearing on capital expenditure decisions. Capital budgeting is the principal instrument for implementing a firm’s strategy. Hence the two should be properly linked. In a decision involving measurement as well as judgment, as far as possible, separate the quantifiable factors and the intangible factors. Strategic planning, among other things, is concerned with the issue of allocating a firm’s resources across different lines of business. In this sense, strategic planning may be viewed as capital budgeting on a grand scale. Strategic planning is often naïve from the financial point of view and / or the results of strategic planning and financial analysis are not properly reconciled.
- 27. In applying DCF analysis, the following mistakes are commonly committed: mechanical projection of cash flows, optimistic bias in cash flows, emphasis on IRR, inconsistent treatment of inflation, and unreasonably high discount rates. To bridge the gap between strategic planning and financial analysis, a conscious effort is required on both the sides. Financial analysts must avoid the mistakes commonly committed by them and strategic planners must understand the logic of the DCF analysis. The behaviour of firms in the real world is often at variance with the textbook model. The discrepancy arises mainly because of informational asymmetries. In theory, managers are supposed to maximize firm value by choosing projects on the basis of their NPVs. In practice, managers look at NPVs as well as the accounting implications of their investment decisions. In particular, they are concerned with the impact of investments on reported earnings in the short run.
- 28. Since a project sponsor is keen to get his proposal included in the capital budget, he is likely to massage the numbers to dress up his project proposal. Is there some way by which such financial manipulation can be checked? McGrath and MacMillan have suggested a process they call discovery-driven planning that has the potential of improving the quality of analysis. In order to be meaningful and viable, the capital budget of a firm must satisfy some conditions: (i) It must be compatible with the resources of the firm. (ii) It must be controllable. (iii) It must be endorsed by the executive management.