Introduction
The goal of the study is to assess
overconfidence bias during acquisitions and mergers within an organization,
especially at the managerial level and make recommendations on how it can be
avoided. Overconfidence during the acquisitions and mergers is not something
new. Over the years, the overconfidence bias has received huge audience from
the media and scholars. For example, the case of Facebook purchasing Whats up
at the cost $19 billion is considered by many experts as an overconfidence
move, that might prove to be costly in the long-run. In the field of
psychology, overconfidence tends to be connected to probability judgment and
calibration. Most of the psychology studies focus on the issue of
overconfidence from the positive illusions point of view. When people they have
positive illusions about an issue they usually make mistakes as their decisions
are informed by emotions rather than proper logical reasoning. According to
Skala (2008), overconfidence can be defined as a particular type of miscalibration,
whereby the probability relating to the given answer to a question being
correct to exceed the appropriate level of the answers accuracy. Overconfidence
bias results in individuals having unrealistic levels of confidence concerning
their capabilities or a given opportunity; such as a manager being
overconfidence concerning an investment opportunity due to bias.
Overconfidence is seen in the field
of management and finance, especially when managers are making investment
decisions. Therefore, those who are overconfident to the extent of being over
ambitious when making investment decisions and in the long-term, they end up
being costly to an organization. In the past, many investment decisions, such
as acquisition and mergers have failed due to the overconfidence of the
management, especially on the capability of the firm remaining profitable (Kind
and Twardawski 2016). Instead of using logic in making major decisions, most of
the managers have used emotion and have ended up coming up with poor decisions.
In the area of mergers and acquisitions most of the decisions that have been
made by managers in large corporations have been impacted negatively by
overconfidence, especially in their capabilities to make things work or
financial capacity of the firm, rather than long-term benefits and cost
implications of such decisions. Thus, there is need of looking at the concept
of overconfidence in the field of finance, especially how they impact on
acquisition as well as merger decisions within a firm.
One of the major findings of this
research is that overconfidence bias results in managers making the wrong
decisions, in the course of determining what investment opportunities to take,
such as available acquisition and mergers opportunities in the market. Overconfidence
bias also results in managers overlooking post-acquisition issues, revenues and
costs as well as considering available cash resources in a firm, instead of the
viability of the project at hand (Doukas and Petmezas 2007). The findings of
the study will assist managers in the future to avoid overconfidence bias when
making decisions related to mergers and acquisitions.
Literature
Review
Most the existing literature
connected to overconfidence does not only focus on psychological aspect but
looks critically at the how overconfidence bias impacts on corporate finance
and financial markets. In the area of financial markets, overconfidence bias
literature tries to explain anomalous findings on investors features and the
way their decision-making process is impacted by overconfidence trait. On the
other hand, when it comes to corporate finance, the existing literature mainly
focuses on issues to do with acquisitions and mergers decisions, investment,
and financing decisions.
One of the major impacts of
overconfidence is in the area of asset pricing. In recent years, various
behavioral financial theoretical frameworks, which are based on the hypothesis
of overconfidence, have been developed with an objective of explaining the
effect of this psychological concept on stock returns. According to Moore and
Healy (2008) overconfidence bias results into investors overreacting to private
information, while at the same time under-reacting to available public
information related to financial markets. Overconfidence results in investors
trading in an aggressive manner in the market, and they tend to underestimate
risks associated with making investments in riskier markets and securities. Brown
and Sarma (2007) notes that overconfidence affects adversely the ability of an
individual investor to make a sound judgment on when to make investments in the
security markers and when not to do so.
Skala (2008) notes that there is a
gender difference when it comes to overconfidence on financial related issues,
whereby, men are overconfidence when compared to women. On the basis of gender,
men trade excessively in the stock markets compared to women. This shows that
men while dealing with financial decisions are more likely to be overconfident
and less cautious when compared to women. Overconfidence results in individual
investors ignoring asset prices and this impact negatively on their returns;
thus, overconfidence bias impacts on the ability of investors to generate
higher returns as one becomes blind to prices that assets are being sold in the
market (Croci, Petmezas and Vagenas-Nanos 2010). This shows that overconfidence
makes investors or managers ignore issues to do with assets pricing by engaging
in excessive trading with an objective of generating higher returns, ignoring
the financial fundamentals of considering the viability of an investment
opportunity before committing any money to it.
Another focus of existing literature
has been in the area of overconfidence among managers as far as corporate
finance is concerned. According to Hribar and Yang (2013), there numbers of
academic literature focusing on consequences of managers who are biased due to
overconfidence have been growing. Hribar and Yang point out that biased
managers usually handle investment and financing decisions in a completely
different way when compared to managers who act in a normal way. Overconfident
managers usually end up pursuing value, which in return destroy the benefits
associated with acquisitions (Croci, Petmezas and Vagenas-Nanos 2010). Ferris,
Jayaraman, and Sabherwal (2013) point out that overconfident manager's end up
making poor judgments regarding earnings expected from acquisitions. The
managers who are overconfident mainly put expected earnings from acquisitions
as higher compared to non-confident managers. Therefore, the ability of
managers to make accurate decisions concerning expected earnings from
acquisitions and mergers is very poor due to their judgment being adversely
affected by overconfidence. Kind and Twardawski (2016) reveals that overconfident managers view
acquisitions and mergers with optimism, while non-confident managers approach
this critical financial process with a lot of caution. Hence, the high levels
of optimism concerning acquisitions end up clouding their judgments concerning
asset pricing and expected returns from an acquisition or merger investment.
Doukas and Petmezas (2007) points
out that overconfident manager are highly optimistic when making an investment
as well as financial decisions. As a result, they end up misusing firm's cash
in investment opportunities that do not make economic sense. The high levels of
confidence result in judgment bias, as they view the investment opportunities
likely to generate higher earnings, even when analysis indicates otherwise (Ferris,
Jayaraman and Sabherwal 2013). The overconfident CEOs make errors when it comes
to sourcing for finances to invest in various projects, such as acquisitions.
The overconfident managers in a business largely depend on cash as source
financing investment projects and this increases organizational risks of cash
flow problems in the case, the acquired assets does not generate cash returns
immediately. However, the non-confident CEO mainly looks for external sources
of finance, such as equity as the basis of helping to raise money to be used in
acquisitions and mergers (Brown and Sarma 2007). When it comes to purchases of
shares, non-confident managers are less likely to purchase company shares in
the market, as they underestimate their real value and fear incurring losses in
the process, but overconfident managers have a higher probability of making
company’s share purchases as they overestimate their real value in the market.
Also, Libby and Rennekamp (2011) argue that
overconfident managers overestimate the future earnings of a firm they intend
to acquire when compared to their counterparts who are less confident.
Therefore, when making future earnings forecasting they fail to be realistic
ignoring factors that might negatively affect the earnings. The poor
forecasting on earning results in the overconfident managers being biased as
they ignore fundamental factors that should be considered when making earning
forecasts within a firm, such as inflation, market trend changes and others. Goel
and Thakor (2008) argues that overconfidence bias impacts on the capability of
the manager to make sound decisions during the merger as well as acquisition
process, as they ignore issues to do with post-merger, such as the impact on
corporate governance and morale of the employees.
Ferris, Jayaraman, and Sabherwal (2013)
point out that overconfidence bias when making acquisition decisions can be
avoided by looking at the historical data of a company and making realistic
earning forecasts. Also, the bias can be effectively addressed through carry
out an adequate assessment of the firm being acquired through undertaking
cost-benefit analysis as the basis for determining the best decision to take.
This aids in eliminating bias that might arise due to the overconfidence of the
management concerning the acquisition and merger process.
Main
Ideas
In the field of corporate finance, one of the
biggest challenges that many organizations face is engaging in mergers and
acquisition decisions that end up being unsuccessful in the long-run. According
to Brown and Sarma (2007), overconfidence bias among senior managers involved
in the process of making acquisitions decisions in a firm is what causes
failure of most of the acquisitions in a firm. The literature review section of
this research reveals some major issues relating to the effects overconfidence
bias, it causes and how it can be addressed by individual managers.
One of the major findings in this research is
that overconfidence bias is a form of the psychological condition, whereby one
has positive illusions concerning everything, even in situations when the
negative illusion is needed (Skala 2008). Therefore, managers who are
overconfident usually have a tendency of viewing everything in a positive way,
such as viewing success in every acquisition project, even in a scenario where
evidence is against such kind of illusion. Overconfidence bias, thus, becomes a
hindrance to the ability of the managers to make sound judgment in various
situations. For example, when a person is overconfident in life, it is
difficult for the person to view things in a realistic way and most cases end
up making a poor judgment in certain situations. This indicates that
overconfidence among managers is a major threat to their judgment capacity within
an organization and this threatens their abilities to make sound financial as
well as investment decisions (Skala 2008).
The major effect of overconfidence bias among
managers about the concept of acquisition decision is they end up making costly
mistakes. When a person is overconfident, the ability to use logic as the basis
of making important decisions is impaired. This situation applies in the case
of corporate finance, where managers abilities to make logical investment
decisions is impaired by overconfidence (Goel and Thakor 2008). An organization
cannot afford to make mistakes in the area of investment, as it ends up losing
financial resources and in worst cases, it can collapse. This indicates that
there is a danger of managers within an organization being overconfident. Most
of the managers who not confident are extremely cautious when making investment
decisions in the area of acquisition, and basis decisions on proper analysis
and this help in eliminating some illusion mistakes. Thus, managers in modern
day organizations should avoid being overconfident when making acquisition
decision for purposes of making sound acquisitions (Goel and Thakor 2008).
On the other hand, the reviewed literature
indicates that overconfidence among managers during the acquisition process
results in the destruction of value associated with this major financial
decision in a firm. Overconfident managers usually overvalue an organization,
as they view its shares being of higher value than they are supposed to be in
reality if a careful fundamental financial analysis is carried out. Thus, there
is a danger of CEOs of firms being overconfident, as they end up buying other
firms at a higher price than they are supposed in reality (Brown and Sarma
2007). When making investment decisions, the basis for deciding on the price to
pay for a firm acquisition should be based on a carefully concluded financial
analysis of the firm being considered for purchase. However, when a manager has
overconfidence bias, emotions instead of logic is what is used as the basis of
arriving at major acquisition decision, and this is a costly affair as the firm
end up paying more than it should for completing an acquisition.
Additionally, the major challenge associated
with overconfidence when making acquisitions investment decision in corporate
finance is an overestimation of earnings of a firm to be acquired or an asset.
For example, a manager who is overconfident will end up making an unrealistic
estimation of earnings to be generated using an asset or acquired firm,
ignoring fundamental financial and economic factors that might impact on
earnings in the future. Therefore, overconfidence result in a manager thinking
in the unrealistic way when making future earnings forecast related to a
particular acquisition (Libby and Rennekamp 2011). In situations where a
manager overestimates future earnings expected from an acquisition, the final
decision will end up being costly to the firm, as huge financial resources will
be used in purchasing a firm that is unprofitable in the long-term.
Also, overconfident managers make a
mistake of using cash as a means of financing acquisitions, instead of looking
for alternative sources of capital. This exposes a company to cash flow
problems in the eventuality that the acquired organization is not profitable as
expected. There is also the danger of ignoring corporate governance issues when
a manager is overconfident during the process of making acquisition decision (Croci,
Petmezas and Vagenas-Nanos 2010). It is critical to consider issues related to
the impact of an acquisition of corporate structure, employee motivation and
culture of a firm, so as to make a sound decision. Most of the firms have ended
up failing due to poor acquisition decisions that ignore corporate governance
issues.
Overconfidence bias can be dealt with using
different ways. One of the best ways is being realistic when forecasting future
earnings. Managers need to be realistic in forecasting expected returns from a
firm that is to be acquired, especially considering all the possible scenarios
so as to make sound investment decisions. The use of historical data can help
to overcome overconfidence bias, as one can understand the trend of firm
performance and use this as the basis for making future projections of what to
expect regarding earnings and return on investment.
Conclusion
The main findings of this research
is that overconfidence bias impacts negatively on the ability of managers
within an organization to make sound financial as well as investment decisions,
especially when considering acquisition and mergers. The managers are
overconfident about their organization's capabilities to succeed through
acquisitions and at times end up being unrealistic when considering certain
decisions. One of the major effects of overconfidence biased as revealed in
this research is an overestimation of expected returns from acquisitions (Brown
and Sarma 2007). Hence, the manager ends up making unsound investment decisions
which are not realistic in nature. This challenge can be dealt with through
carrying out realistic of expected earnings from an acquired firm in the
future. Also, this research reveals that
overconfidence makes managers make poor judgments as far as asset pricing is
concerned. For example, due to poor judgment, most of the male managers who are
more likely to be overconfident compared to women end up investing excessively
in stock purchases, without considering asset prices, generating lower returns
in the long-run. There is also the problem of overvaluing assets or firm being
acquired when a manager is overconfident. This clearly shows that managers
should avoid being overconfidence to eliminate judgment biases associated with
this psychological condition. The research indicates that overconfidence bias
can be dealt with during acquisitions by managers through undertaking realistic
forecasting of earnings, careful assessment of the problem being address and
use of historical data to predict future performance of an organization (Ferris,
Jayaraman and Sabherwal 2013).
The concept of overconfidence bias
is important in the field management as well as finance. Given that managers
are the ones responsible for authorizing acquisitions decisions within a firm;
they are supposed to ensure that make accurate decisions without being
overconfident as this affect their logical reasoning negatively. Therefore, the
concept of overconfidence bias and its negative effects provide the basis of
managers understanding the importance of being realistic while making major
decisions within an organization. The concept help raises major questions
regarding whether overconfidence within the right context can positively
influence the success of a firm during mergers and acquisitions. This shows
that future studies should focus on this area so that conclusive information
can be gained on whether overconfidence positive influences mergers and
acquisition decisions in a firm or its effects are only negative ones.
Additional articles
Emile Durkheim studies focus on the elements that make people try to commit suicide. He looks at the different factors of the life ending choices that people consider before making the final push. The findings of Durkheim’s work are influenced b...Types-of-Suicide,-Emile-Durkheim …
Read ArticleDemand and Supply Supply and interest is maybe a standout amongst the most basic ideas of mass trading and it is the spine of a Macy’s Company economy. Interest alludes to the amou...Demand-and-supply-curves-of-Macy's,-Inc.-(M)-company- …
Read ArticleHarnessing Freedom: Exploring the Dynamics and Principles of Democracy The term democracy refers to power by the people. It is a system of government associated with the people having control over leadership and governance. In this s...Harnessing-Freedom:-Exploring-the-Dynamics-and-Principles-of-Democracy …
Read Article