Bachelor Thesis

Hot and Cold Deal Markets: “Real options as remedy for valuation biases?”

Abstract:Activity in mergers and acquisitions (M&A) deals over the years show a pattern of occurring in waves. This

occurrence comes with some negative consequences, such as reduced competition as well as firms becoming

larger to the point that they are ‘too big to fail.’ The phenomenon, also referred to as ‘hot’ and ‘cold’ deal

markets, may have various causes. In this thesis the cause concerning personal-level uncertainty biases of

executives and the effect on their valuations is given attention. This thesis seeks to compose an experiment that is

able to test the validity of a proposed real options solution by Smit & Lovallo (2014). By creating a setting in which

the relevant biases can affect valuation, the experiment introduces real options as a countermeasure to these

biases to see whether executives are susceptible for real options. If the experiment can provide evidence for this,

this could justify further research into this subject and ultimately justify real options analysis to be a standard

consideration in every valuation decision. Note that the conduct of the experiment and the interpretation of the

results is subject of a future paper: this paper is solely concerned with the composition of the experiment.

Author: Flint van der VlistStudent number: 358509Date: August 28th 2014Word count: 9982Thesis supervisor: Prof. dr. Han T.J. SmitFaculty: Erasmus School of Economics (ESE)University: Erasmus University Rotterdam (EUR)

Keywords: hot and cold deal market, valuation biases, real options, composition experiment

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Table of contentsIntroduction.................................................................................................................................................2

Theoretical Framework...............................................................................................................................5

Methodology.............................................................................................................................................19

Concluding Remarks..................................................................................................................................26

Bibliography...............................................................................................................................................27

Appendices................................................................................................................................................29

Appendix A: Discounted cash flow valuation with horizon value..........................................................29

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Introduction

It has been repeatedly shown that mergers and acquisitions (M&A) occur in waves, with the earliest

wave dating as far back as the late 1890s (The Economist, 2012a). This means that in some periods

markets are hot and many deals are done. Inversely, when this is not the case, markets tend to be cold

and few deals are done. Becketti (1986) has provided evidence for a positive relationship between

merger activity and the business cycle. This implies that the decisions by executives are biased by

behavioral errors during different phases of the business cycle, which results in hot and cold deal market

situations. In a hot deal market, executives tend to be optimistic and consequently exaggerate the

growth possibilities associated with an acquisition or venture, whilst in a cold deal market, executives

tend to be pessimistic and therefore focus more on the risk inherent in an acquisition or venture. The

fluctuations in the amount of deals caused by the biased valuations give rise to different problems. One

of those problems concerns the sudden tightening of the market, consequently reducing competition in

the market. Furthermore, the most predominant problem caused by the recent waves of M&A activity is

that the merging companies become ‘too big to fail’. This means that if the now larger companies get

into financial distress, the government will have to intervene (The Economist, 2012b). It is therefore

imperative to seek out possible solutions in order to dampen the occurrence and magnitude of hot and

cold deal markets.

One of those possible solutions is provided by Smit & Lovallo (2014). They propose a synthesis of

behavioral finance and a real options approach for debiasing the valuations in hot and cold deal

markets. They state that due to the perception of executives of acquisitions and ventures as go/no-go

decisions, there exist biases in valuation in hot and cold deal markets. As previously stated, executives

tend to be overly optimistic about growth opportunities in hot deal markets, whilst in cold deal markets,

executives are reluctant to make deals due to an emphasis on risk. Seen in the light of the most

commonly used valuation method, the discounted cash flow method (DCF), the growth inherent in the

horizon value is exaggerated in hot deal markets, while the initial outlay and the overall risk in the

project is focused upon in cold deal markets, with little to no attention given to the horizon value (see

Appendix A). In other words, the perception of the uncertainty inherent in the acquisition or venture

gives rise to biases in valuations.

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These cognitive biases have been subject to extensive research. Kahneman & Lovallo (1993) discuss

various of these cognitive biases, which, in the light of the hot and cold deal market, can explain the

behavior of executives. The explanation for the overvaluation in hot deal market can be found in the

overoptimism and overconfidence bias, whilst the undervaluation and relatively few deals in the cold

deal market situation can be explained by loss aversion and narrow framing. Smit & Lovallo (2014) also

regard herding behavior of competitors and anchoring as a driving force of the hot and cold deal

markets. However, these possible explanations for the hot and cold deal markets are not what this

paper aims to study. This paper will solely look at previously mentioned personal-level uncertainty

biases of executives. Through these biases, the possible solution, the real options approach, proposed

by Smit & Lovallo (2014) will be treated.

This real options solution focuses on the uncertainty inherent in acquisitions and ventures. Basically, the

solution attempts to dampen the effect that optimism and pessimism of executives has on the amount

of deal done, by respectively trying to evoke a feeling of caution and venturing. The idea is that this can

be achieved by making executives aware of the real options inherent in acquisitions and ventures. In hot

deal markets, where many deals are done and overvaluation is present, executives should be made

more cautious in order to temper the amount of deals done. Smit & Lovallo (2014) propose that options

to defer or to stage investments should be acknowledged by executives in order to make executives

aware that acquisitions are not necessarily go/no-go decisions. In cold deal markets, with few deals

being done, executives should become more venturing by improving the perception of value in the

targets and consequently increasing the amount of deals done. By making executives more aware of

growth options, options to abandon investments and options to switch, the tendency to focus on risk

can be dampened as well as redirecting the focus to the growth opportunities in potential investments,

thereby reducing the undervaluation.

The contribution of this paper can be found in the composition of an experiment in which the proposed

solution of Smit and Lovallo (2014) is empirically tested in a controlled environment. Firstly, the

participants will be framed as executive of a fictional company. They will be able to earn real cash,

depending on the decision made as well as chance event. After this, the experiment will test whether

there is indeed a discrepancy in the valuation of ventures (with a horizon value) between executives in

hot and cold deal markets, by framing groups of participants in hot and cold deal market settings by

drastically changing their initial endowment. Secondly, the experiment seeks to research whether real

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options are noticed by participants and how they perceive them when the options are made increasingly

explicit. Ultimately, the goal is to find out whether raising awareness among participants about the

presence of different real options in ventures effectively affects their further valuations. In other words,

to find out whether executives are susceptible for real options. If this is the case then making real

options analysis standard in every valuation decision could indeed provide a solution for the occurrence

and magnitude of the hot and cold deal market phenomena. Important to note at this point is that this

paper does not yet conduct the experiment; it is solely concerned with the composition of the

experiment. The conduction of the experiment will be subject of a future extension of this research, and

will be therefore be reported in a different paper. The main question the experiment that will be

composed will seek to answer, and thus, what the experiment is ultimately based upon is as follows:

“How does the introduction of real options in ventures affect the valuation of these ventures by executives in a hot and cold deal market setting?”

In the next section of the paper, the theoretical framework will be covered. Firstly, a detailed discussion

of the conventional valuation methods is covered, after which an overview of the relevant cognitive

biases will be given. Next, the cognitive biases will be explained in conjunction with the relevant

conventional valuation method, thereby providing an explanation for the hot and cold deal market

phenomenon, based on these personal-level uncertainty biases. After this extensive description of the

problem and its causes, a short overview of the debiasing possibilities will be given, after which the real

options approach will be covered. The theoretical framework will be concluded with an overview of the

experimental literature. Throughout the theoretical framework the goal is to come up with hypotheses,

which are based upon the explicit link between the described problem and the real options approach as

the solution, as proposed by Smit & Lovallo (2014). The experiment will be composed by creating a

setting in which answers to these hypotheses can be found. After the discussion of the theoretical

framework, the process of composing the experiment will be covered, with an extensive consideration

for the choice of structure and formulation of the questions. The paper will be concluded by giving an

overview of all the considerations and limitations made during the composition of the experiment, as

well as some important suggestions about the conduction of the experiment and future compositions of

experiments regarding this topic.

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Theoretical Framework

In this section of the paper the theoretical foundations upon which the experiment will be based is

treated. By first giving a proper description of the problem this paper seeks to test a solution of by

composing an experiment, the relevant factors will be fenced off from the factors which will not be given

further consideration in this paper. After this, an overview of the relevant real options will be given, after

which the proposed solution by Smit & Lovallo (2014) will be explained by combining the described

problem with the properties of the explained real options and thereby explaining the proposed possibility

to debias the valuations. Near the end of the theoretical framework the hypotheses will be posited,

which will reflect the theoretical expectations. These expectations will be the basis for the experiment.

The section concludes by providing a short overview of considerations offered by the current

experimental literature.

As briefly explained in the Introduction, the scope of this paper is to compose an experiment that can

test a solution for personal-level uncertainty biases of executives giving rise to the hot and cold deal

market situations, via distorted valuations. Therefore, the other causes Smit & Lovallo (2014) posit,

among which herding behavior, anchoring to distorted multiples and groupthink, will not be given

further attention in this paper. The focus here will be on the personal-level uncertainty biases of

executives as cause for the hot and cold deal market phenomena.

To understand the effect of these personal-level uncertainty biases on the valuation of ventures, which

in turn gives rise to the hot and cold deal markets, a brief overview of the relevant valuation methods is

essential, before going in depth on how different biases influence the valuations obtained from these

methods. There are two primary method used in valuations, the discounted cash flow (DCF) method and

multiples analysis. The latter however will not be given further attention in this paper, as it has more to

do with the other possible causes of the hot and cold deal markets (anchoring to distorted market

multiples). The DCF method is the method in which future cash flows of an investment opportunity are

discounted against a particular discount rate, in order to obtain the net present value (NPV) of that

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investment opportunity. The general rule of thumb is to accept an investment opportunity if the NPV of

this project exceeds 0 (Berk & DeMarzo, 2014). As long as the aforementioned future cash flows can be

estimated with relative confidence, this is desirable. However, when this is no longer the case, a so

called horizon value should be established (see Appendix A for an example of an overview of a DCF

analysis of an investment opportunity). This horizon value can be perceived as the value left due to this

investment opportunity at the end of the planning period. By discounting the horizon value back to

present and adding it to the present value of the other cash flows, the NPV for the investment

opportunity is obtained. This horizon value can be estimated in various ways, among which the

perpetuity growth model and the exit multiple approach. In the former, a perpetuity, an estimated cash

flow expected to be received in regular intervals for eternity, is discounted by the difference in the cost

of capital and the growth rate, in order to obtain the horizon value (Brealey, Myers, & Allen, 2011). This

method of estimating the horizon value however is prone to crude estimations and assumptions

regarding the growth rate and is therefore subjective to biases. In the latter, the exit multiple approach,

the horizon value is estimated by valuing the hypothetical situation in which the investment is sold after

the period in which the cash flows can still be estimated with a fair amount of confidence. The value of

the investment opportunity is obtained with a so called multiple (financial ratio), such as enterprise

value / earnings before interest and taxes (EBIT). These multiples are based on market values of

comparable projects or companies. The horizon value obtained from this method is therefore by default

dependent on the comparability of the market investment opportunities.

As the horizon value often determines a large portion of the total value of an investment opportunity,

the methods used to estimate it should be as objective and precise as possible. However, as described

above, in reality this is not the case. The estimation of the horizon value can differ greatly, dependent on

the interpretation of future growth or the choice of comparable multiples. As in hot and cold deal

markets executives tend to respectively over- and undervaluate investment opportunities, the presence

of cognitive biases in conjunction with the sensitivity of the DCF method to the horizon value could be

regarded as a possible reason for the occurrence of hot and cold deal markets.

As the relevant valuation method has now briefly been explained, one can now take a closer look at the

cognitive biases that influence the valuation. In the context of the subject of this paper, the following

cognitive biases are regarded as most predominantly of influence on the valuation in hot and cold deal

markets: overoptimism, overconfidence, loss aversion and narrow framing, each of which will be treated

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below. After this theoretical explanation, the link will be made with the DCF valuation method, thereby

providing an explanation for the occurrence of hot and cold deal markets.

Overoptimism and overconfidence bias

Smit & Lovallo (2014) suggest that overconfidence and overoptimism in executives can cause

overestimated horizon values. This gives rise to the question what the difference between these two

concepts is. Overoptimism bias is the tendency for people to think they are more likely than others to

experience positive events and less likely to experience negative events (Helweg-Larsen & Shepperd,

2001). With positive events, the bias causes people to be confident and feel well, and could possibly

cause people to feel overconfident. This overconfidence may also give rise to a new bias, which means

the people influenced by it to think they can effectively influence risks, whilst in reality they cannot.

However, in case of negative events, people affected by the bias tend to take more risk without paying

much attention to the consequences that are affiliated with their actions (Weinstein & Klein, 1996). In

short, overoptimism bias refers to excessively optimistic expectations about exogenous factors.

Overconfidence refers to the situation of being excessively confident about one’s own abilities,

performance or the level of control one has over situations (Wilkinson, 2008). Moore & Healy (2008)

distinguish three different manifestations of overconfidence, namely overestimation, overprecision and

overplacement. Overestimation refers to overestimating one’s control over the situation, one’s abilities

and chances for success. Overprecision refers to excessive certainty regarding the accuracy of one’s

beliefs (Wilkinson, 2008). Overplacement refers to one’s feeling of being ‘better than average’. All of

these forms of overconfidence could play a role in the valuation of targets. More on this after the

theoretical treatment of the cognitive biases.

The literature regarding overconfidence distinguishes various factors which have an effect on or are

affected by overconfidence, or both. One of these factors is the illusion of control. Illusion of control is

the phenomenon in which people assume that they have influence on the outcome of an uncontrollable

situation (Langer, 1975). In other words, people in suffering from illusion of control underestimate the

predominant role of randomness on the outcome of certain situations. There are factors that amplify

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this illusion of control, namely competition, familiarity, the possibility to decide and degree of

involvement.

A different factor enhancing overconfidence is the confirmation bias. Confirmation bias is the

phenomenon in which a person invests a disproportionate amount of time in accumulating information

which confirms a hypothesis you strongly believe in (Jones & Sugden, 2001). Self-attribution is the

closely related phenomenon where a person discounts information which is contradictive to one’s

belief, thereby firmly holding on to that belief, regardless of the information indicating otherwise

(Wilkinson, 2008).

The concept ‘overconfidence’ has also been subject for research in the field of mergers and acquisitions.

One of these researches has shown that some indicators for CEO overconfidence have a relationship

with the premiums paid in acquisitions. Those indicators included most significantly historical

performance of the company and attention of the media about the CEO (Hayward & Hambrick, 1997).

Another research has shown that overconfidence, in the presence of cash reserves in a firm, can induce

overinvestment (Malmendier & Tate, 2005).

Loss aversion bias

Loss aversion is the phenomenon that people weigh losses heavier than they do gains. In terms of

money, the aggravation people experience from losing a certain amount of money exceeds the pleasure

people receive from gaining that same amount (Kahneman & Tversky, 1979). Due to aversion for losses,

people tend to become risk averse when confronted with choices regarding outcomes which consists of

both negative and positive gains.

One of the most straightforward evidences for loss aversion is given by Kahneman & Tversky (1979).

They showed that people have a tendency to reject the following gamble (or comparable gambles): “win

€110 with probability 0.5, lose €100 with probability 0.5, independent of other risks”. It is apparent that

gambles of this form have positive expected value. Under the traditional, normative expected utility

theory, this gamble should therefore be accepted. Namely, as the gamble is independent of other risks,

this gamble provides one with an opportunity to diversify its risk. The observation that people tend to

reject this gamble, is therefore indicatory for the presence of an aversion for losses. Kahneman &

Tversky (1979) have described this phenomenon by positing a descriptive theory, the so called prospect

theory. A thorough treatment of this theory is beyond the scope of this paper. For further understanding

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of prospect theory, one should consult the original papers regarding this topic (Kahneman & Tversky,

1979; Tversky & Kahneman, 1992).

Kahneman & Tversky (1979) show the aversion for losses by a kink at the origin in the value function

between the area for gains and losses, where the origin reflects the reference point at hand. This is

shown in Figure 1.

Figure 1: A hypothetical value function (Kahneman & Tversky, 1979)

As can be seen in Figure 1, the value function is convex in the area for losses and concave in the area for

gains. Moreover, the curvature is steeper in the area for losses than in the area for gains, indicating loss

aversion. The magnitude of this loss aversion has been subject for various researches. Expressed as a

‘loss aversion coefficient’, indicating the amount of units ‘gain’ required to offset one unit of ‘loss’, the

findings indicate this coefficient to be somewhere in between 2:1 and 2.5:1 (Tversky & Kahneman,

1991). The phenomenon of loss aversion is one of the reasons risk aversion exists among people facing

decisions under uncertainty and risk, as people tend to avoid situations which expose them to potential

losses, whilst potential gains may be much higher or more likely to occur.

This is also the case in organizational contexts. Kahneman & Lovallo (1993) even argue that loss aversion

in executives can be even larger, due to the fact that they are ultimately responsible for the outcome of

the decisions. They argue that there is an asymmetry between credit and blame, which can enhance the

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magnitude of loss aversion in the executive’s utility function. Consequently, this increased manifestation

of loss aversion among executives may induce more risk averse behavior.

Thus, it is now established that executives have a proclivity for loss aversion, which consequently

induces risk averse behavior. As this paper seeks to compose an experiment in order to test the real

options solution (this solution will receive further attention later in this section) on the valuation

decisions of executives, it is important to understand how prior outcomes of decisions of the executive

affect the attitude of said executive. In other words, how does a prior gain or loss influence the

executive’s attitude toward risk? The literature regarding this subject does not yet provide a clear-cut

answer. There are currently two interpretations that have gained in support: the house-money effect

and the escalation of commitment view. As the outcome of prior decisions will be used as a way to

frame the participants of the experiment (more on this later), it is imperative to understand the

different considerations about these two interpretations. Therefore, a brief overview of both views will

now be provided.

The house-money effect is the observed effect that a prior gain increases a person’s willingness to take

risk, whilst a prior loss decreases this willingness to take risk (Thaler & Johnson, 1990). They conducted

the following experiment among students (undergraduate and MBA):

1. You have just won €30. Choose between

a. A 50% chance to gain €9 and a 50% chance to lose €9

b. No further gain or loss

2. You have just lost €30. Choose between

a. A 50% to gain €9 and a 50% chance to lose €9

b. No further gain or loss

Option (a) was preferred by 82% of the participants in Situation 1, whilst only 36% chose Option (a) in

Situation 2. In other words, the prior gain induced more risk seeking behavior, whilst the prior loss gave

rise to risk averse behavior. However, this result in the area of losses no longer holds if the decision in

situation 2 comprises an opportunity to break even, which is appropriately called the break-even effect

(Thaler & Johnson, 1990). Thus, if it possible for the subject to cancel out the previous loss by gambling,

the integration of the outcomes is facilitated, giving rise to risk seeking behavior (Kahneman & Tversky,

1979). The phrasing of the situation (the framing) does play an important role in this, as this can

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influence the ease with which a subject can integrate the outcomes. More on framing will be provided

later on in this section.

The escalation of commitment is the observation that contradicts the house-money effect. In other

words, it is the observation that after prior gains a person’s willingness to take risk decreases, and vice

versa for prior losses (Weber & Zuchel, 2005). This observation can be explained by taking a closer look

at the value function under prospect theory (see Figure 1). Initially, the origin represents the reference

point. If a person with this value function now experiences a gain, the reference point will move into the

area for gains. A new decision will now be evaluated with respect to this new reference point, which,

due to the concave shape of the value function in the area for gains, now causes this person to be more

risk averse. Inversely, experiencing a loss moves the reference point into the area for losses and will

make the person more risk seeking. Therefore, prior gains and losses affect future decisions due to the

change in risk attitude reflected in the value function. However, it has to be noted that this ‘escalation of

commitment’ observation holds only if the initial decision is perceived as ‘initiating a course of action’

(Weber & Zuchel, 2005), which is understandable given the theoretical explanation provided by the

value function under prospect theory. Namely, if the decisions seem to be independent and separate

from one another, the reference point shifts back to the original point in the origin.

Framing effects, the manner in which a decision is presented to a person, play a role in the two views

treated above. Therefore, framing (and narrow framing) will now be given more attention to, after

which the concepts of loss aversion (and the related risk aversion) and narrow framing will be linked

with each other, thereby providing an explanation as to why the phenomena of hot and cold deal

markets occur.

Narrow framing

One of the basic assumptions of rational choice theory is invariance, which assumes consistency and

coherence in people’s choices (Wilkinson, 2008). This implies that the presentation of any choice should

not influence the eventual decision. However, many studies have shown that these conditions do not

hold, if the presentation of the same choice is changed from a positive to a negative phrasing, or vice

versa. This cognitive bias is called framing effects. It describes the phenomenon where people make

different choices dependent on the presentation of the question as losses or as gains (Tversky &

Kahneman, 1981). Framing effects are among the most prominent phenomena in behavioral economics

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(Wilkinson, 2008). Narrow framing is such a phenomenon. To grasp the concept of narrow framing, one

should first recall traditional utility theory. This theory states that a person given a decision involving

risks should evaluate this decision by mixing the risks inherent to the decision with the risks the person

already faces over the total wealth of said person in order to establish whether the decision to be made

is either attractive or unattractive (Barberis & Huang, 2008). Narrow framing is the observation that such

decisions or gambles are evaluated in isolation of all other risks a person already faces. Tversky &

Kahneman (1981) have shown this in their classic experiment:

“Imagine that you face the following pair of concurrent decisions. First examine both decisions, and then

indicate the options you prefer.

Choice 1: Choose between

A. A sure gain of €240,

B. A 25% chance to gain €1,000 and a 75% chance to gain nothing.

Choice 2: Choose between

C. A sure loss of €750,

D. A 75% chance to lose €1,000 and a 25% chance to lose nothing.”

As the subjects are asked to first examine both decisions before indicating which of the options they

prefer, the subject should integrate the outcome of the options of Choice 1 and Choice 2 and then

determine which of the options in these two situations are preferable. This should cause them to opt for

B&C as the expected integrated outcome of this gamble is: [25% chance to gain €250, 75% chance to

lose €750]. This outcome clearly dominates the expected integrated outcome of A&D: [25% chance to

gain €240, 75% chance to lose €760]. However, 84% of the subjects opted for A and 87% chose for D

(thus, only 16% opted for B and a mere 13% opted for C). This indicates that subjects do not focus on the

combined outcome of decisions, as traditional utility theory prescribes, but subjects tend to isolate

decisions and their outcome, disregarding indirect impact of their choice on total wealth. In other

words, people tend to look directly at the outcome of a single decision and they examine whether that

decision is attractive. Concluding, narrow framing is the focus on the outcome of a single decision,

without appropriately taking into account the other risks one already faces.

There are two interpretations as to what the underlying sources of narrow framing may be, both of

which may provide explanations as to why the hot and cold deal market phenomena occur. One of these

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interpretations focuses on the non-consumption utility ‘regret’. In this regard, regret is seen as the pain

caused due to the realization that one would have been better off now if a different choice was made in

the past (Barberis & Huang, 2008). Consequently, this would explain why one frames narrowly: as the

pain due to the regret is explicitly tied to a specific choice made in the past, the exposure to future

regret is taken into account in the decision making process now. In other words, the possibility of

making a decision now that turns out to be bad in the future shies people away from making that

particular decision, independently of any other risks. Therefore, the existence of regret could be an

explanation for the tendency to not appropriately merge the risk of the decision at hand with the other

risks a person already faces. Important to note is that one can of course also regret not having taken a

decision in the future (e.g. not investing in a particular stock after which the price of this stock

skyrockets). However, research has shown that regret of making a decision (errors of commission) is

more painful than the regret of not making a decision (errors of omission) (Kahneman & Tversky, The

psychology of preferences, 1982).

The second interpretation of a possible underlying source of narrow framing is provided by Kahneman

(2003). Kahneman distinguishes two systems of thinking and decision making, which respectively

corresponds to intuitive thinking and reasoning, which he labels System 1 and System 2 conform

Stanovich & West (2000). In short, System 1 represents intuitive thought, which operates fast,

automatically, effortlessly, largely emotionally charged and associative, and is therefore hard to control.

In contrast, System 2 represents reasoning, which operates slower, effortful, controlled and is to a large

extent rule-governed (Kahneman, 2003). Kahneman continues by introducing the concept of

‘accessibility’. He argues that narrow framing occurs when decisions are made more intuitively as

opposed to effortful reasoning. The accessibility of the features of the decision are therefore of

paramount importance. If certain aspects of a decision are not accessible enough to a decision maker,

this will increase the likelihood that the decision is framed too narrowly, thereby not taking into account

other risks or opportunities.

Hot and cold deal market in relation to valuation through cognitive biases

The theoretical considerations regarding the valuation methods and the cognitive biases of

overconfidence, loss aversion and narrow framing have now been sufficiently covered, such that it is

now possible to describe the expected effect hot and cold deal markets have through the

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aforementioned cognitive biases on the eventual valuation. The expected relationships will form the first

hypotheses which the experiment will seek to find answer to.

First, it is important to see that a positive correlation between the business cycle and M&A activity

(thus: hot and cold deal markets) has readily been established (Becketti, 1986). This means that

executives in a hot deal market are near the top of the cycle and are likely to have experienced recent

gains. This recent gain in turn amplifies the overconfidence inherent in executives, as they are likely to

attribute these recent successes to their own abilities. This increased degree of overconfidence in

executives is then expected to increase valuation of new ventures by these executives, as they are

overoptimistic about the future of this venture, expressed in an overestimation of the horizon value in

the DCF analysis. This reasoning leads to following hypothesis:

Hypothesis 1: “The valuations of executives who have recently experienced a gain are higher than

valuations of executives without any prior experience.”

If Hypothesis 1 holds, this would provide evidence to the statement that recent gains, characteristic to a

hot deal market, amplify overconfidence, which in turn leads to a higher valuation of the venture in

question, due to overestimation of growth possibilities inherent in the horizon value. If Hypothesis 1

does not hold, this could either imply that the prior gains are not significant enough (or in terms of the

experiment: the framing was not successful), or more extremely, that prior gains do not truly have a

relationship with overconfidence.

Given the established positive correlation between business cycle and M&A activity, it can be derived

that executives in a cold deal market are near the bottom of the cycle and are thereby likely to have

experienced recent losses or setbacks. Assuming that the house money effect holds, this recent loss

would induce risk averse behavior. If this executive then has to valuate a new venture, this risk averse

behavior should be reflected by a conservative valuation, as the risk inherent to the initial outlay is

weighted relatively more. This reasoning leads to the following hypothesis:

Hypothesis 2a: “The valuations of executives who have recently experienced a loss are lower than

valuations of executives without any prior experience.”

However, if one is to assume the escalation of commitment effect to be dominant, the prior loss could

induce more risk seeking behavior among these executives. In a valuation this should be reflected by a

more opportunistic valuation of the venture.

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Hypothesis 2b: “The valuations of executives who have recently experienced a loss are higher than

valuations of executives without any prior experience.”

As Hypothesis 2a and Hypothesis 2b are mutually exclusive, the results of the experiments will have to

provide the answer as to which of the two expectations hold. Given the outcome, one should look

critically at the experiment and results to see whether the framing as executives has been sufficient. If

this turns out not to be the case, this affects the results and one should therefore take that into account

whilst interpreting the results.

After having established whether there exists a difference in valuations between groups with a prior

gain/loss (‘hot deal market framing’/’cold deal market framing’) and groups without any prior

experience, testing whether a valuation difference exists between groups with respectively a prior

experienced gain and a prior experienced loss. Following the same reasoning and assuming the house

money effect to hold in the ‘cold deal market framing’, the following hypothesis should hold:

Hypothesis 3: “The valuations of executives who have recently experienced a gain are higher than

valuation of executives who have recently experienced a loss.”

After answering these three hypotheses, it is time to see whether the proposed solution, a real options

approach, for the hot and cold deal market phenomena by Smit & Lovallo (2014) could be feasible. In

order to explain how they propose to use real options to mitigate these phenomena, it is first imperative

to explain the real options that are important with regard to this topic. In the context of this research

there are four relevant real options: options to defer, growth options, options to abandon and options

to switch. Each of these options will now be shortly discussed. The valuation of real options will not be

discussed: this is not relevant given the goal of this paper.

Option to defer

As described above, it is conventional wisdom to commit to a project if the NPV is positive. However, it

is sometimes better to wait with committing. By waiting, one obtains an option to defer (also known as

an option to stage, an option to wait and learn, and a timing option). Basically, this is a call option on an

investment project. This call option is exercised by committing to the underlying project. By waiting

(deferring) instead of immediately investing, one can obtain additional information and consequently

more certainty about the future of the project. This option to defer becomes increasingly valuable as

uncertainty about the project increases, as well as relatively small immediate cash flows, which are lost

due to the postponement of the investment (Brealey, Myers, & Allen, 2011).

16

Growth option

An investment project should not be solely evaluated on the basis of the NPV, as this would imply that

only projects with a positive NPV would be carried out. In reality, many projects contain possible follow-

on projects contingent on the commitment to the initial project (Brealey, Myers, & Allen, 2011). In other

words, the initial project contains call options of follow-on projects in the future. These call options are

however not accounted for in the static DCF method of valuating projects. By properly accounting for

these type of real options, the commitment to projects which initially have a negative NPV could now be

justified.

Option to abandon

The option to abandon is a put option on the underlying assets of a project (Brealey, Myers, & Allen,

2011). In principal, this is a limited insurance against possible failure of the project, when the underlying

assets have at least some salvage value. If the project then turns out to be unsuccessful, the losses can

be reduced by selling these assets. Ignoring these abandonment options would give rise to an

undervalued project. By evaluating the expected salvage value over the time of the project and using

this as augmentation to the DCF method, some projects with an initial negative NPV can justifiably be

embarked upon (Pike & Neale, 2006).

Option to switch

The option to switch has two different interpretations. On the one side, the option to switch involves the

possibility of changing the inputs in the production of a particular output product, due to so called

process flexibility. As the market price or demand may shift over the duration of the project, having the

flexibility to change which inputs are used in the production process is valuable, especially if input

factors are subject to high price volatility . On the other side, the option to switch can also entail the so

called product flexibility; the possibility of changing which output products are produced in a facility

(Smit & Trigeorgis, 2004). This option to becomes more valuable as markets are volatile. Both product

flexibility as process flexibility options to switch should be regarded when evaluating a project, as both

can add significant value.

Now the relevant real options have been covered, the link with the initial problem can now be made, in

order to then be able to explain the proposed solution of Smit & Lovallo (2014). The DCF method is a

static method for decision making (NPV > 0, then commit, otherwise not), and therefore can create a

sense of certainty and control among the executives in charge. However, by approaching decisions

regarding new ventures with from a more dynamic point of view, thereby focusing more on the

17

uncertainty inherent in projects, this would augment the decision making process and could lead to

better decision making.

This is where real options provide an opportunity. As previously mentioned, the existence of hot and

cold deal markets suggests that valuations are biased over the cycle: overvaluations occur in hot deal

markets, undervaluations in cold deal markets. Real options can help to mitigate this in both situations:

real options can be used as either a venturing argument in cold deal markets, as well as a cautionary

argument in hot deal markets. Given the four described real options above, the option to defer can be

seen as real option providing a cautionary argument. By introducing this option in hot deal markets, the

executives should realize that only partially committing to the project might be more valuable than fully

committing immediately. By waiting the uncertainty regarding the future of the project might be, in

part, resolved.

Inversely, in cold deal markets too few deals are done due to undervaluation. The growth options,

options to abandon and options to switch provide a venturing argument in this regard. As stated before,

in the DCF analysis the horizon value makes up a large part of the valuation. Uncertainty is inherent in

the horizon value, and as executives in cold deal markets are too focused on risk, they tend to ignore or

grossly underestimate the growth potential a new venture can provide. Therefore, by introducing the

three options stated above into the decision making process of said executives, they will have to pay

more attention to the horizon value and future of the project, instead of mainly focusing on the risk,

thereby undervaluating the venture.

In short, the solution proposed is that making real options analysis a standard part in the decision

making procedure, this will objectify the valuations, as executives now are explicitly pointed to the

uncertainty inherent in new ventures. Thus, by making real options more explicit in the valuation

process, this will lead to debiased valuations, and ultimately improved decision making. The question

now is, are executives susceptible for real options? If so, then real options might indeed be a good

solution to the hot and cold deal market phenomena. If not, then this provides indication for the

statement that real options might not be a good solution, or at least, that more teaching about real

options is needed before it becomes a viable solution. This leads to the following hypothesis:

Hypothesis 4: “The valuations of executives in hot and cold deal markets are relatively higher after

explicitly introducing real options, compared to their previous valuations.”

18

As all the real options considered are value-enhancing, all the valuations should become higher after

having made the real options more explicit. This would provide indication for the statement that

executives are susceptible for real options and that making these real options a standard part of any

valuation decision could possibly serve as solution for the hot and cold deal market phenomena. The

goal of the experiment is to test whether this susceptibility is present. The next section will cover the

composition of the experiment.

Methodology

In this section of the paper the experiment is composed and will be explained step-by-step. Firstly, the

general idea and goal of the experiment will be covered. Secondly, a link with the previous theoretical

section will be provided and all considerations will be explained and the choices will be justified. The

experiment will be added as an addendum to this paper (so not added within this paper or its

appendices).

Goal of the experiment

The goal of the experiment composed in this paper is twofold. Firstly, it should test whether there is in

fact a discrepancy in the valuation of a venture between subjects framed in a hot and cold deal market

setting. As covered in the Theoretical Framework, the expectation is that subjects framed in a hot deal

market tend to focus on growth and thereby exaggerate the horizon value. Subjects framed in a cold

deal market are expected to focus more on the risk inherent in the horizon value, thereby giving

conservative valuations. Secondly, the experiment seeks to answer the question whether executives are

susceptible for real options. If the real options get recognized once they are made more explicit, which

could debias the valuations in both hot and cold deal markets thereby reducing the initial difference in

19

valuations. In short, the experiment seeks to answer the question whether real options could reduce the

magnitude of the hot and cold deal market waves by verifying whether executives are sensitive to these

options once they are made more explicitly aware of their existence.

As can be induced from previous paragraph, the test subjects will be framed into either a hot deal or a

cold deal market setting. They will also get slightly altered questions. The manner in which this is done,

will be explained in the remainder of this section. However, in order to be able to verify whether the

results of the experiment confirm or reject the hypotheses, there will be two control groups. One of the

control groups will be given the same questions as the hot deal market subjects, the other control group

will be given the same questions as the cold deal market subjects. The only difference between the

control groups and the hot and cold deal market groups, is that the control groups will not be framed

into a hot and cold deal market setting. By doing so, it is now possible to control whether the chosen

measure for framing the subjects does in fact frame them in that way, as well as to see whether the

recognition of real options differs between the test group and the control group. All groups will be of

similar size: with sample size N, each group (A through D) will comprise N/4 subjects (see Table 1 below).

Table 1: Overview of test group A&C and control group B&D, each consisting of N/4 subjects

Hot deal questions Cold deal questions

With framing Group A Group C

Without framing Group B Group D

Now that the goal of the experiment has been covered, it is now time to discuss the subjects of the

experiment.

Subjects of the experiments

This experiment requires at least some preliminary knowledge of financial economics, namely the

interpretation of a discounted cash flow analysis. Therefore, the sample will be drawn from all the

students who have at least once followed a financial economics related course or seminar. In order to be

able to make statistical inferences about the eventual results of the experiment, a sample size of at least

20 per group (A-D) is necessary, because this would provide the opportunity to test the hypotheses with

the use of a t-test. A smaller sample size per group could lead to less reliable and robust results. A larger

20

sample size is desirable. However, as the subjects receive monetary remuneration, which on average

will be approximately €10,-, this totals to €800,-. If each of the four groups (A-D) has a sample size larger

than 20, the financial means at the disposal of this experiment might be exhausted, making larger

sample sizes unrealistic.

The subjects will be evenly and randomly assigned to each of the four groups, thereby assuring that

group A-D is of equal size and thereby more easily comparable with one another, as well as making sure

there are as little confounding variables as possible that could possible skew the results.

When conducting the experiment the subjects will be put into isolated booths with only a computer

running the experiment present. The choice for using a computer during the conduct is made, because

this gives the conductors full control of what information the subject receives. The reduces any potential

noise from conducting the experiment in person or in groups. Also, the computer provides the

possibility to give the questions in a sequence chosen by the conductors, thereby making it easier to

insert the desired manipulations. The subjects will not be provided a calculator: all questions will have to

be made intuitively.

Position in the experiment

The test subject will assume the position of CEO of a fictional firm, called KeenScreen, which is an

established company in the market for electronic devices. The company has a particular valuation at the

start of the experiment (t=0), expressed in points. This valuation will be different for hot and cold deal

market and control group subjects. During the course of the experiment the subject will be asked to

make various valuation decisions, which can either increase or decrease the company’s valuation. It is of

paramount importance that the subjects believe that they can effectively influence the future valuation

of the company by making good decisions, but they also should be able to realize that the chance state

of economy plays a large role as well, which they can then take into account and adapt for. The

compensation of the executive will be equal to the company’s valuation, measured in points, at the end

of the experiment.

The valuation of the company will be continuously provided to the subject in the corner of the computer

screen. This is done in order to try to keep the subject focused on improving this company valuation, as

well as keep the subject reminded of a relatively high or low valuation (compared to the first valuation),

which is required for the framing in hot and cold deal markets.

21

The goal of Part One is to introduce the test subject into the role of CEO, as well as introducing the

company, after which the participant will have to make a simple binary decision. After this decision, the

test subject will either be framed in a hot deal market or in a cold deal market.

First, the test subject is given a description of the company (s)he’s about to assume the role of CEO of,

namely KeenScreen, a company producing numerous electronic devices. This will establish the mindset

of a CEO, which is enforced by providing an extensive company description, including past successes.

The subject has to adequately feel as if (s)he’s now in charge of a well-established company.

Furthermore, the description is to give the subjects the opportunity to identify real options inherent to

this company and its industry. In the description numerous suggestions are made for possible real

options. Firstly, KeenScreen is established in the Netherlands, but also has locations in Belgium and

Germany, which points to possible options to expand. Secondly, from previous successes of KeenScreen

described, it can be inferred that there is a significant possibility for know-how spillover between the

product lines of KeenScreen, indicating possible growth options. Thirdly, the description explains that

some of the technology used by KeenScreen can be sold for salvage money or used in different product

lines, indicating options to abandon or options to switch.

Depending on the group the subject is assigned into, the company valuation will be different. For hot

market subjects, the valuation will be 600 points. This will be 1,400 points for cold market subjects. The

control groups will both be 1,000 points. The valuation will be graphically illustrated, including past

valuations. All of this is done in order to enforce the managerial mindset.

Now the subject has been appropriately framed into the role of CEO, the hot and cold deal subjects will

be asked to make its first managerial decision. Note that the control group will not get this first

question, as this group should start the next question as blank as possible. This decision entails a

possible geographical expansion to either Sweden or Norway. It is important to note that no additional

information is given, so the subjects have to make a judgment call based on their own perceptions of the

costs and benefits associated with each of the two countries. The eventual answer to this question is

irrelevant. It is only important that the subject has made a decision, and therefore feels partly

responsible for future performance of KeenScreen. The great amount of freedom the subject has in

determining the best option increases the likelihood that he/she accepts the results to be their doing

(even if it in fact is not). The importance of this feeling of responsibility lies in the fact that the framing in

the next part of the experiment will not be effective if the subject does not attribute the upcoming

22

valuation to be at least partly his/her doing (which could in turn lead to overconfidence in the subject

about his/her skills).

After the irrelevant decision for Sweden or Norway, the subject will now face the first valuation after

(s)he’s assumed the role of CEO. Group A had a valuation at t=0 of 600 points and will now experience a

gain of 400 to 1,000 points. Group C had a valuation at t=0 of 1,400 points and will now experience a

loss of 400 to 1,000 points. Control groups B and D have not participated in the first question and will

remain at 1,000 points. A brief explanation of the factors accounting for the new valuation will be

provided. This includes the choice for expansion, as well as chance state of the economy. However, the

magnitude of each of these factors on the valuation is not specified. This will give each subject room for

interpretation. Hot deal subjects are likely to attribute the gain to their decision, thereby becoming

more overconfident. Cold deal subjects could attribute the results to the business cycle and therefore

uncertainty. The subjects have now been framed in hot deal, cold deal and control groups, which all

have a valuation of 1,000, which is important, because of the various effects potential liquidity

differences could have on later decisions.

Part Two concerns the first valuation question based on a DCF analysis with an uncertain horizon value.

The question will be exactly the same for each of the four groups.

The question starts off by again emphasizing the current value of the company and whether the subject

has experienced a gain or a loss. The description concerns a decision about a new technology, which

would enable KeenScreen to produce TV’s of higher quality. The technology is called UltraHD, but it is

not explicitly stated that the technology is solely usable for their television product line, which gives rise

to growth options. KeenScreen can obtain the right to use this technology by paying InnovaTV, the

research company which invented UltraHD, a license fee. KeenScreen’s competitors are interested as

well, but only one company can obtain the license. The license is put up for auction. The reason for using

an auction it to obtain a valuation which is close to the true subjects’ reservation price. As it is an

auction, only one can obtain the license. It is important for the subject to realize the now-or-never

character of the decision. After the auction, there is no more possibility to obtain the license. As this

license could open up future growth options via know-how spillover, losing the auction would put a

definitive end to these opportunities.

Before having to make a bid for the license, the subject is provided a forecast of the future cash flows of

the application of the new technology in their TV product line. This forecast leaves the horizon value

23

open for interpretation by the subject. It is provided that each year there are at least some fixed costs.

This is done in order to make the subjects aware that the horizon value could also turn out negatively, if

the expected revenues after the planning period are, in their perception, low. The revenues of the

project UltraHD consist of the positive cash flows in the planning period, together with the uncertain

horizon value. The costs associated with the project are the cost of implementation, as well as the

amount paid for the license. The discount factor is 0 in order to simplify the situation.

By analyzing the bids made on the license, the valuations of the horizon value can be derived. The

horizon value is the combination of the amount bid for the license fee and the residual obtained after

deducting the (absolute value of the) costs of implementation by the positive cash flows in the planning

period. It has to be noted that the assumption is made that the bid is equal to the reservation price.

Part Three is different for group A&B and C&D, because now the real options will be implemented,

according to the solution provided by Smit & Lovallo (2014). Group A&B will be presented a situation

including an explicit option to stage, which represents the caution argument. Group C&B will be

presented a situation including an explicit growth option, representing the venturing argument.

The subject (Group A&B) is now informed that before the auction has taken place, InnovaTV has

approached them with an offer to start a joint venture. In this venture both the revenues and costs

would be evenly split between KeenScreen and InnovaTV. Upon the acceptance of this joint venture,

KeenScreen would also receive a clause, which gives them the opportunity to buy out InnovaTV’s share

in the joint venture after six year (and only then) for the same price as KeenScreen paid to buy into the

joint venture (See cash flow projections). InnovaTV has also approached the other players in the market

and still demands a license fee. The subject now has to come up with a price for this license fee.

By analyzing the new offer for the license fee, the conclusion that the subject values the clause (which is

in fact an option to stage) could be drawn, if this bid is at least more than half of the original bid in Part

Two.

After having come up with the price for the license fee, the subject is informed that the board of

directors wants a revised clause in the joint venture, which allows KeenScreen to buy out InnovaTV at

any moment after six years. The subject again has to make a new offer for the license fee to InnovaTV.

As the clause is always more valuable now then it was in the previous question, the price offered for the

license fee should be higher. If this is the case, the conclusion can be drawn that there is in fact

awareness of options and that subjects now how (at least in part) how to value them.

24

In contrast, the subject (Group C&D) gets new information before the auction takes place. The subject is

now explicitly informed of a growth option. The right to use the technology makes implementation in

the smart phone product line feasible, but no sooner than five years after project UltraHD TV has

commenced (as know-how about this technology has to accumulate over the period of executing

UltraHD TV). The subject is also notified about the conditionality of this growth option on winning the

auction now. This is characteristic for growth options, as growth options only arise from a commitment

at an earlier moment in time. The success of possible implementation in the smart phone market is

uncertain, because of economic circumstances. If the market turns out to be favorable for implementing

Ultra HD Smartphones, the magnitude of the cash flows (in and out) will be twice as large as those

associated with project UltraHD TV. If the market turns out to be unfavorable, implementation will

result in an annual loss of 10 for the upcoming ten years. This loss remark should be irrelevant, as the

subject should realize that implementation if the market is unfavorable is not mandatory. Given this new

information, the subject is asked to make a bid for the license fee.

By analyzing the new bids, the conclusion that subjects value the growth option can be drawn, when the

subjects offer a higher bid than in Part Two.

Again, before the auction has taken place, the subject gets new information. An unfavorable market

after five years does not mean that this attitude will endure. The subject is told that the market’s

attitude could change, although the likelihood of this occurring diminishes as time progresses. The

subject is given some information about the chances and degree of diminishment, but for drawing

conclusions this is irrelevant. The only thing the subject needs to realize is that, due to this possible

market attitude change, the option is worth more than it was before, and therefore the license is worth

more.

At the end of the experiment the test subject will receive the amount of points in company valuation in

cash with a conversion rate of €1,- per 100 points. The subject will receive random feedback on the

eventual results of the last questions. Some of the subjects will go up, others will go down, but not too

much. This gives the conductors the opportunity to distribute the money within the limits of the budget,

as well as give the subjects the feeling that they had influence over this outcome.

25

Concluding RemarksThe goal of this paper was to compose an experiment which could test whether real options could

provide a solution to the behavior of executives causing the hot and cold deal market phenomena. After

an elaborate explanation of how valuations of new ventures are most commonly done and how

cognitive biases influence these valuations in hot and cold deal markets, the composition of the

experiment was treated. The composed experiment has been elaborately covered with a step-by-step

explanation and justification for each consideration or formulation. However, as this paper’s goal was

solely the composition of the experiment, no results have been gathered to interpret and therefore no

conclusion can be drawn on the basis of this paper. The conduct of the experiment will be the subject of

a future paper, after which interpretations and answers will be given to the hypotheses and research

questions the composed experiment seeks to test.

After the composition of the experiment some possible additions or alternatives to possible future

experiments were found. Firstly, by giving the subjects another case, one could verify if the subjects

improve in their valuations. Secondly, it could be interesting to make twice as many groups and give half

of the groups an instruction on the subject of real options, so they are familiar with the topic. This

26

should improve the susceptibility to real options and hence increase the likelihood of these groups to

see these options in the description of the valuation problems. Comparing the valuations of the

instructed groups with the uninstructed groups could then uncover whether there are teaching effects

to real options. This could give important extra insight into the feasibility of real options as a solution for

hot and cold deal markets.

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Appendices

Appendix A: Discounted cash flow valuation with horizon value

Figuur A.1: Discounted cash flow valuation; importance horizon value

t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 H o r i z o n v a l u e

Cash flow

Time

NPV

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?

?