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Unformatted text preview: Session 1 - Behavioral Foundations (Ch. 1) Overview Chapter 1 introduces the 10 key psychological phenomena that serve as foundation concepts for the behavioral approach to corporate finance. The chapter begins with a short summary of the traditional approach to corporate financial decisions, emphasizing risk, value maximization, and agency conflicts. The remainder of the chapter introduces the ten psychological phenomena through a series of examples that illustrate how these phenomena can affect the decisions managers make, the risks they take, and the impact on the values of their firms. These 10 phenomena are organized into the following three groups: 1. biases (4) 2. heuristics (4) 3. framing effects (2) Biases and heuristics are introduced using examples taken from the experiences of the firm Sun Microsystems, notably its chief executive officer Scott McNealy. Framing effects are introduced using examples taken from the experiences of the firm Merck & Co. Thematic boxes called Behavioral Pitfalls boxes provide the relevant background data for each firm. The main objective of the chapter is that we want you to be able to demonstrate that you can identify the 10 psychological phenomena that cause corporate managers to commit expensive mistakes when making decisions. The three specific checks are that you should be able to: 1. Identify the key biases that lead managers to make faulty financial decisions about risky alternatives. 2. Explain why reliance on heuristics and susceptibility to framing effects render managers vulnerable to making faulty decisions that reduce firm value. 3. Recognize that investors are susceptible to the same biases as managers, and that mispricing stemming from investor errors can cause managers to make faulty decisions that reduce firm value. The chapter questions and mini-case appearing at the end of the chapter provide the primary vehicles for testing whether we have met the learning objectives. T raditional T reatment of Corporate Financial Decisions Financial managers are called upon to make several types of decisions about sources and uses of funds in their firms. In theory, managers represent the interests of shareholders and make value maximizing decisions. However, managers might have different interests than shareholders, with the resulting conflicts of interest being known as agency conflicts. Behavioral T reatment of Corporate Financial Decisions Psychological phenomena often generate obstacles that interfere with managers abilities to make value maximizing decisions. Because psychologically induced mistakes can be, and often are, very expensive, studying behavioral corporate finance is vital. Remedies required to address behavioral phenomena are typically different from the incentive-based remedies required to address agency conflicts....
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