Why Corporate Finance is a misnomer and how behavioral corporate finance can help…

Interesting paper by Prof Ulrike Malmendier of UC Berkeley.

She starts the paper with this emphatic statement:

The field of Corporate Finance might well be the area of economic research with the most misleading name (followed by Behavioral Economics as a close second). Many of the research papers identified as “Corporate Finance” deal neither with corporations nor with financing decisions. In this chapter
of the Handbook, I first conceptualize the breadth and boundaries of Corporate Finance research, and then present the advances that have resulted from applying insights from psychology. I illustrate how the behavioral toolbox has allowed for progress on long-standing puzzles regarding corporate
investment, mergers and acquisitions, and corporate financing choices.

She says much of corporate finance is too narrow and fails to include topics which are relevant today:

The two figures convey an idea of the (stereo-)typical research topics in corporate finance, but, as acknowledged earlier, fail to capture where the field stands today, with its much broader set of actors and actions, research questions, and methodologies. Examples of research closely tied to non-finance fields include contracting in micro-finance (development economics), corruption and its detection in the stock market (political economy), the allocation of human capital within firms (labor and organizational economics), and the incentives and biases of stock analysts (accounting).4

So what, then, distinguishes Corporate Finance from other areas of applied microeconomics? First, while the set of actors and actions in corporate finance models might be broad, it still has to feature some elements of the set “firm, manager, investor, analyst, entrepreneur” as they are involved in mergers, equity issuance, and other corporate decisions. Second, there continue to be differences in empirical methodology, such as standard-error calculations using the Fama and MacBeth (1973) approach, and event study methodology to evaluate the net value creation in, say, earnings news or merger announcements.5 At the same time, we also see convergence from both sides. Petersen (2009) clarifies the differences between the Fama-MacBeth approach and clustering, and anticipated the move to clustering as Fama-MacBeth standard errors will frequently be too small.  Vice versa, applied microeconomists outside corporate finance are now embracing the event study methodology and aggregate difference-in-differences approach.

How will behavioral corp fin differ?

With these definitions and caveats in mind, I turn to Behavioral Corporate Finance, which applies tools and insights from Behavioral Economics to corporate finance settings. Let’s define Behavioral Economics following Rabin (2002) as an approach that allows for

1. deviations from rational belief formation,
2. non-standard utility maximization, and
3. imperfect maximization processes due to cognitive limitations

Need to read the whole paper which is 100 plus pages…phew..

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