[MUSIC] So now, we're going to talk about, does loss aversion potentially affect corporate finance decisions? Okay remember, shareholders CEO, leadership of the firm, they're humans as well. Or they maybe subject to this loss aversion affect? Okay so again, right off the top, let's bring in Le Penseur for a pause, think and answer. So, some question about loss aversion and takeover offers. So suppose you want to take over two firms, let's just call them Firm A and Firm B. So Firm A, stock price has fallen recently and is far below its 52-week high-level. So Firm A, stock prices kind of really fallen recently. Firm B, on the other hand, the stock price has risen recently and is just below it's 52-week high, okay. So, which firm shareholders will require you to offer at a higher premium to buy its shares? They both have the same price and value today, but it got there different ways. So, which firm's shareholders require the higher premium to buy its shares? Firm A, Firm B or will each require the same premium? Give that some thought and then I'll give you my take. So, what did you think? Which firm shareholder should require you to give them a higher premium for you to take them over? You might think, hey, the price is the same for these stocks. They have the kind of same kind of value, it would be kind of same premium for both, okay. Economically, the past all time or past 52-week high, it's economically not relevant today, right? That's what's in the past, we just care about what is the economic situation today, but this past 52-week high or past all time high may be benchmarks that investors or you have in mind. And therefore, could be very, very relevant if there is enough shareholders are loss averse. So if shareholders are loss averse and this loss averse is important, it might be actually a tougher to acquire Firm A. If shareholders have in mind, hey, I remember what our price was just earlier in the year, we've fallen a light from that. I really don't want to realize this psychological loss, so it might be hard to acquire Firm A, because those shareholders might be thinking hey, I should get a price that's roughly what the 52-week high was, because that might be a salient benchmark in my mind. For Firm B, the price is already close to that 52-week high. So you offer a little premium, you can just get above that. That might cause those shareholders to be happy to sell. But for Firm A, when the gap is very wide, it might be much harder to convince those shareholders to accept a price that is lower than the past 52-week high even though economically this past 52-week high is kind of irrelevant, it's in the past. So, loss aversion and takeover offers. Baker, Pan and Wurgler study the effect of reference points like the 52-week high on the merger and acquisition market. They find that offer prices for target firms are sensitive to the target's past 50-week high stock price. So when takeover offers are being put together, there's evidence that people are aware of the importance of this 52-week high as a benchmark for the target shareholders, okay? For example and offer's chance of success jumps discontinuously when the offer price exceeds the 52-week peak. So, this is like psychologically important for target shareholders. If you can offer a price that is just a little above this 52-week high, it just makes it more likely that the target shareholders will accept your takeover offer. But the market responds more negatively to the bidder, the acquirer when a takeover offer is influenced upward, because of the peak price of the target. So, that's an interesting result like the market seems to be able to figure out, hey, you may be paying too much to acquire this firm, because you're having to pay this high price to psychologically convince the target shareholders to go along with the deal. But that's just transferring wealth from you, the acquiring firm to the target firm, to psychologically please them. That's bad from the perspective of the shareholders of the bidder or the acquiring firm, okay. So some interesting result there regarding how loss aversion may effect the take over market, let's pose another question here. The CEO may also have personal benchmarks that effect decision making of the firm. What would be a relevant benchmark for the CEO in terms of stock price? What's likely a relevant benchmark for the CEO of the firm? Okay, how would this benchmark affect the likelihood that the CEO's firm sells stock to raise cash for the firm? So, what would be a relevant stock price benchmark for a CEO? Given this, how would this benchmark affect the likelihood that the CEO's firm sells stock to raise cash for the firm? So not the CEO selling stock of their own, the CEO's firm selling equity to raise cash for the firm. So, think about this and then I'll give you my take. So, let's think about this. Okay, I think you could think of multiple benchmarks, but I think a natural benchmark for the CEO would simply be what is the stock price when that CEO joined the firm? Okay, I'm sure that's something that would be kind of salient in the CEO's mind, how could this affect the likelihood that the CEO's firm sells stock to raise cash? Well, a natural hypothesis would be that the CEO might be very reluctant to sell, have the firm sell stock if the stock price has fallen below the level when the CEO started his or her tenure at the firm. So CEO joins, the stock price is a hundred. If the price goes down to like 80, if the CEO's kind of loss averse might be, I don't want to sell the stock for the firm at 80. Because psychologically, that's kind of, I'm admitting that hey, things have not gone well since I joined the firm. I just might want to avoid that realization of making that kind of explicit by selling the stock at a lower level than when I joined. So, I just may be less likely to do that. So, we're not the first people to kind of think of this hypothesis. Malcolm Baker and my colleague in Illinois, Yuhai Xuan find that the stock price when a CEO joined the firm is indeed a relevant benchmark for the firm's equity issuance decision. So just as we hypothesize, that's what they actually find doing some empirical analysis, okay. So, this benchmark is not important when the CEO is replaced. So for example, when they find evidence that CEO joins, stock price is high. Stock price falls, that causes the firm to be less likely to sell stock. Maybe because the CEO feels like, I'm realizing a loss by doing so. But once you've fired that CEO, the new CEO comes in, that new CEO, it doesn't matter what happened with the prior CEO. They don't have that personal attachment to the past stock prices. So then the new CEO is much more willing to have the firm sell stock, if that's needed to raise capital. So there's this interesting conclusion that hey, if a firm has had past poor stock returns, they may need to actually fire the current CEO if they need to raise capital by selling stock. Because the loss aversion, the psychology may prevent the current CEO from selling stock if the price is declined, but a new CEO doesn't have that pass link to the past prices. And therefore, it's more willing to sell stock psychologically. Okay, so next up, we'll talk about explanation of potentially for the momentum strategy. There's loss aversion, potentially explain kind of momentum strategy. But before that, stay tuned for another faculty focus episode. I'm kind of always proud to show this logo here with the magnifying glass and who do we have up? Of course, Yuhai Xuan, a colleague of mine here at Illinois and also the Academic Director of the iMBA program. We'll talk to him about his work, about the importance of CEO benchmarks in terms of influencing corporate decisions. So, be sure and stay tuned for that. [SOUND]
