14  Bounded awareness

14.1 A puzzle

Consider this puzzle from Bazerman and Moore (2013).

You represent Company A (the potential acquirer), which is considering acquiring Company T (the target) by means of a tender offer.

The value of Company T depends on the outcome of a major oil exploration project that it is currently undertaking. If the project fails, the company under current management will be worth nothing ($0 per share). But if the project succeeds, the value of the company under current management could be as high as $100 per share. All share values between $0 and $100 are considered equally likely.

However, Company T will be worth more in the hands of Company A than under current management. In fact, the company will be worth 50 percent more under the management of A than under the management of Company T. If the project fails, the company will be worth $0 per share under either management. If the exploration project generates a $50 per share value under current management, the value under Company A will be $75 per share. Similarly, a $100 per share value under Company T implies a $150 per share value under Company A, and so on. It should be noted that the only possible option to be considered is paying in cash for acquiring 100% of Company T’s shares. This means that if you acquire Company T, its current management will no longer have any shares in the company, and therefore will not benefit in any way from the increase in its value under your management.

The board of directors of Company A has asked you to determine whether or not to submit an offer for acquiring company T’s shares, and if so, what price they should offer for these shares. This offer must be made before the outcome of the drilling project is known. Company T will accept any offer from Company A, provided it is at a profitable price for them. It is also clear that Company T will delay its decision to accept or reject your bid until the results of the drilling project are in. Thus you (Company A) will not know the results of the exploration project when submitting your price offer, but Company T will know the results when deciding on your offer. As already explained, Company T is expected to accept any offer by Company A that is greater than the (per share) value of the company under current management, and to reject any offers that are below or equal to this value. Thus, if you offer $60 per share, for example, Company T will accept if the value under current management is anything less than $60.

As the representative of Company A, you are deliberating over price offers in the range of $0 per share (this is equivalent to making no offer at all) to $150 per share. What price offer per share would you tender for Company T’s stock?

14.2 Evidence

What do people offer to acquire the company?

The first group given this problem, MBA students, tended to bid between $50 and $75 per share (Samuelson and Bazerman (1985)). A typical explanation is that the average outcome for company T is $50, making the value for company A $75. Any offer in the range between these two values would be agreeable for both parties.

But let’s think through a specific number.

What if we made an offer of $60? If we make an offer of $60 it will be accepted 60% of the time - whenever the firm is worth between $0 and $60 for company T. Since all those values are equally likely, the firm will be worth on average $30 to company T when they accept, meaning it will be worth $45 on average for company A. A $60 offer will result in an average loss of $15.

Generalising this, any offer of $X that is accepted will have an expected value of $X/2 for firm A. The expected value is therefore 1.5($X/2)=0.75($X). For any positive value offer, we can see that any offer above $0 generates a negative expected return, a loss of 25% of the offer.

The analytical logic here is not difficult. But most people do not initially see it. Typically less than 10% of respondents offer $0. People systematically exclude information from their decision making process that they have the ability to include. They fail to see that their expected return depends on acceptance by the other party, which is subject to the true value which only they know. Acceptance is most likely to occur when the value is lower.

This behaviour remains even when participants are paid for performance and given opportunities to learn through experience (Grosskopf et al. (2007)).