Behavioral Finance and Valuation Syllabus Spring 2015 Prof. Anna Scherbina Email: ascherbina@ucdavis.edu UC Davis Graduate School of Management Tel: 530.754.8076 Office: 3212 Gallagher Hall e-mail: ascherbina@ucdavis.edu Course Focus Capital markets are not perfectly efficient. Investor psychology and market frictions can cause prices to persistently deviate from their fundamental values, creating profit opportunities for sophisticated investors. The course will cover various techniques of financial analysis with the goal of learning how to value assets and identify mispricing. Throughout the course, we will learn about behavioral biases of managers, entrepreneurs, and individual investors, agency problems in corporations and investment funds, and the role of investor activism; we will also study various asset-pricing anomalies and limits to arbitrage that prevent the anomalies from being completely eliminated. The course is largely based on Harvard Business School cases and group exercises. Corporate Finance course is strongly recommended as a prerequisite. Consult with faculty if this can be waived. Prerequisites Corporate Finance Course Materials Textbooks: 1. Behavioral Corporate Finance by Hersh Shefrin, 1 st edition*, McGraw- Hill 2. Inefficient Markets: An Introduction to Behavioral Finance, by Andrei Shleifer, Oxford University Press 3. Principles of Corporate Finance by R.A. Brearly, S. Myers, and F. Allen, 11 th edition* *These textbooks will be used for background readings only, and earlier editions are also fine. Chapter assignments depend on the edition. Reading assignments are subject to change. You may skip the mathematical descriptions of models in Shleifer s book. ** Cases and supplemental materials are available on study.net 1
Course Format Case analysis will involve building Excel models and conducting sensitivity analysis to assumptions in support of the final recommendation. Due to the labor-intensive nature of case preparation, I strongly encourage students to work in groups to get ready for class. Attendance and participation are essential parts of the learning process for this course. I expect students to attend all scheduled sessions and to come prepared to contribute to the discussion. Reading assignments should be read in advance of class, and everyone is expected to participate in discussions. If you have a compelling reason for missing a class, you should inform me in advance (email is best). Missing classes will affect your grade; missing any without reasonable cause is likely to do so significantly (see participation grading scheme below). Evaluation Final grades will be computed as: Class participation 40% Homework 20% Final Project 40% Class Participation Class participation is a very important part of the learning process in this course. A major part of your final grade (40%) will be based on an assessment of the quality of your contributions to class discussions. Homework There will be two homework assignments. Final Project The final project involves preparing a detailed report on the assigned topic and showing all relevant analysis in Excel. 2
Recommended reading: 1. Behavioral Corporate Finance: An Updated Survey, by M. Baker and J. Wurlger (posted on the HBS course website) 2. H. Shefrin, Behavioral Corporate Finance, Chapters 1, 5, and 8 3. R.A. Brealey, S. Myers and F. Allen, Principles of Corporate Finance, Chapters 7.3 and 13 4. A. Shleifer, Inefficient Markets: An Introduction to Behavioral Finance, Chapters 1-6 The course is comprised of seven modules: COURSE SCHEDULE Module 1: Delegated portfolio management, performance evaluation, stock return anomalies Module 2: International markets Module 3: Investor activism Module 4: Entrepreneurship, behavioral biases in negotiations Module 5: Real options Module 6: Real estate markets Module 7: Asset bubbles, limits to arbitrage 3
LIST OF CASES: Module 1: Delegated portfolio management, performance evaluation, stock return anomalies Class 1: Class 2: Introduction Carol Brewer s Investments AQR momentum strategies Module 2: International markets Class 3: Extracting information from international stock markets (no case assigned, please bring your laptops to class) Module 3: Investor activism Class 4: Kerr-McGee Module 4: Entrepreneurship, behavioral biases in negotiations Class 5: Behavioral Negotiations (no case assigned, please bring your laptops to class) Module 5: Real options Class 6: Merck Module 6: Real estate markets Class 7: Class 8: Stedman Place: Buy or Rent? Pilgrim Assurance Building 4
Class 9: Health Development Corp. Module 7: Asset bubbles, limits to arbitrage Class 10: Asset price bubbles (no case assigned, please bring your laptops to class) CASE QUESTIONS: Module 1 Class 1 Case: Carol Brewer s Investments Case questions: 1. How did Marshfield perform? Did its investments out-perform or underperform the market? 2. Suppose Marshfield charges a fee of 1% and a passive index fund would charge a fee of 0.15%. Is that difference in fees significant? 3. Define the following terms: return, mean return, return variance, standard deviation of returns, covariance of returns, correlation of returns, regression analysis, beta, R-squared. 4. Using the data in Exhibit 4 of the case: a. Compute mean returns and return standard deviations for Marshfield, the S&P 500 index, and the Russell 3000 Value index. b. Compute the covariance and correlation between Marshfield and the S&P 500. c. Create an xy graph with Marshfield s Equities returns on the y- axis, and the S&P 500 returns on the x-axis. Plot the regression line (Select Chart, Add trendline, Options and click Display equation on chart as well as Display R-squared value on chart ). d. Create a column of annual returns for a portfolio that each year was invested 50% in the S&P 500 index and 50% in U.S. treasury bills, beginning in 1990. Plot these returns vs. the S&P 500 index return on the same chart as in question 4c. 5. What does this analysis tell us about Marshfield s performance? 6. Does it make sense for Carol Brewer to have reduced her allocation target for equities below 100%? 7. How have U.S. stocks performed relative to U.S. bonds over the long term? How risky are stocks versus bonds? 5
8. Compute mean returns and return standard deviations for each of the asset categories in U.S. Annual Returns tab of the Capital Market Returns Data spreadsheet. 9. Compute the covariance and correlation between U.S. stocks and U.S. treasury bonds. 10. Create a column of annual returns for a portfolio that each year was invested 75% in U.S. stocks and 25% in U.S. treasury bonds. Calculate the mean and standard deviation of returns for this portfolio. Do the same for other stock/bond combinations, e.g. 50%/50% stocks/bonds, 25%/75% stocks/bonds, etc.. Can you explain how the mean return of the portfolio changes as the percentages in stocks and treasury bonds vary? Can you explain how the standard deviation of the portfolio changes as the percentages in stocks and treasury bonds vary? Class 2 Case: AQR s Momentum Funds (A) and (B) Case questions: 1. Should AQR launch its momentum funds? 2. Do you believe the Fama-French momentum factor will have returns over the next decade that are significantly greater than zero, significantly less than zero, or approximately zero? Use the historical data to do your analysis and come to class prepared to defend your conclusion. 3. What are the appropriate benchmarks for AQR s momentum funds? Will the net performance of the funds exceed those benchmarks? Why or why not? 4. Does momentum make an attractive product for retail mutual fund investors? 5. If AQR launches its momentum funds, how should the firm weigh maximizing returns vs. minimizing tracking errors? How should it manage the portfolio? Module 2 Class 3 Lecture and Exercise in extracting macro information from equity markets Please bring your laptops. Module 3 Class 4 Case: Kerr-McGee Case Questions: 1. What is the NPV of exploring for oil? 2. What is the value of KMG? 6
3. What is the optimal corporate structure of KMG? Class 5 Behavioral negotiations Please bring your laptops. Module 4 Module 5 Class 6 Case: Merck & Company: Evaluating a Drug Licensing Opportunity Case Questions: Assume that all cash flows are already discounted (or the discount rate is 0%) 1. How has Merck been able to achieve substantial returns to capital given the large costs and lengthy time to develop drugs? 2. Build a decision tree that shows the cash flows and probabilities throughout the FDA approval process. 3. Should Merck bid to license Davanrik? How much should they pay? 4. What is the expected value of the licensing arrangement to LAB? Assume a 5% royalty fee on any cash flows that Merck receives from Davanrik after a successful launch and that the present value of benefits are net of royalties. 5. How would your analysis change is the costs of launching Davanrik for weight loss are $255 million instead of $100 million as given in the case? Module 6 Class 7 Case: Stedman Place Case Questions: 1. What is the cost of renting? 2. What is the cost of buying? 3. Identify the key assumptions and key unknowns that influence the buy-versus-rent decision. Class 8 Case: The Pilgrim Assurance Building Case questions: 1. How much is the building worth to Mr. Bailey? 2. How much is the building worth to a diversified competitor? 3. How much should Mr. Bailey bid? 7
Note: In addition to the expenses detailed in the case, assume that beginning in 2011 David Bailey will incur annual tenant improvement costs and leasing commissions that together average $5 per square foot for the entire building and grow with inflation. These costs can be considered capital expenditures and are depreciated straight-line over 39.5 years. Assume that Bailey's tax rate is 35% and that capital gains are taxed at 15%. Class 9 Case: Health Development Corporation Case Questions: 1. Did the purchase of the Lexington Club real estate increase the pre-tax value of HDC? 2. Why does the Lexington Club real estate purchase reduce the office prices? Does it make sense? 3. How would you structure the deal? Module 7 Session 10 Lecture and Exercise on asset bubbles and behavioral finance Please bring your laptops. 8