Topic 9 - Managerial Optimism and Myopia Flashcards

1
Q

When are managers taken to be optimistic?

A

When they systematically overestimate the probability of good firm performance and underestimate the probability of bad firm performance.

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2
Q

What is Free cash flow?

A

The cash flow above that needed to fund current positive NPV projects.

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3
Q

What do Myers and Majluf (1984) believe in regards to FCF?

A
FCF is beneficial: 
because managers (loyal to existing shareholders) have information the market does not have. They will sometime decline positive NPV projects if it means issuing under valued stock to under-informed capital market. The financial slack provided by large amount of FCF prevents this socially and privately undesirable outcome.
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4
Q

What does Jensen (1986) believe in regards to FCF?

A

FCF is costly:
because of a conflict between managers and shareholders.
- Managers want to retain FCF and invest them in projects that increases managerial private benefits (like compensation, power, reputation, empire building).
- Shareholders want managers to pay out FCF, because the projects that increase managerial private benefits may be negative NPV ones.

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5
Q

How does Jensen (1986) believe that agency cost can be avoided?

A

increasing debt transactions that bond the firm to pay out FCF can increase shareholder value and mitigate the conflict of interest between shareholders and managers - disciplining role of debt.

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6
Q

What is Heaton (2002) view on FCF?

A

that there is an underinvestment-overinvestment tradeoff related to free cash flow from managerial optimism (without invoking asymmetric information and agency costs.)

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7
Q

How does FCF benefit optimistic managers according to Heaton (2002) if they believe that capital markets undervalue their firm’s risky securities ?

A
  • (prefer internal financing)
  • may decline positive net present value projects that must be financed externally, believing that the cost of external finance is too high
  • FCF can thus be valuable by preventing social and private losses from under-investment
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8
Q

How does FCF impact optimistic managers according to Heaton (2002) if managerial optimism causes systematically upward biased cash flow forecasts?

A
  • will cause managers to overvalue their own firm’s investment opportunities
  • Optimistic managers may wish to invest in subjectively positive but objectively negative net present value projects
  • FCF makes it easier for managers to take on negative NPV projects as they don’t need to seek external funds.
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9
Q

According to Heaton (2002), through which two factors are benefits and costs of FCF linked?

A

(i) the level of managerial optimism;

(ii) the investment opportunities available to the firm.

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10
Q

According to Heaton, when does a shareholder prefer FCF to be retains and when do they prefer the FCF to be paid out?

A

Retained - when high optimism and good investment opportunities
Paid out- when high optimism and poor investment opportunities

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11
Q

According to Heaton is an optimistic the manager more or less likely to seek external financing? What issue does this cause and when is this issue worsened?

A

Less likely,
Causes underinvestment issue.
The better the firms project the worse the under investment issue.

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12
Q

What are the 4 assumptions made in Heaton’s model?

A

A1 - info on firms CF and investment opportunities are available simultaneously to the capital market and the manager
A2 - Managers take on all positive NPV projects
A3 - Securities prices always reflect discounted expected future CF under the realistic probability distributions.
A4 - The capital market is risk-neutral and discount rate is zero. (no tax/ fin distress costs)

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13
Q

According to Heaton (2002), How does the model differ for optimistic managers? i.e. probability of return at t2?

A

Their optimism means that they predict a higher probability of return than the market for both the initial and subsequent investment.

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14
Q

According to Heaton (2002), what is the pecking order for type of financing used to fund optimistic managers positive NPV projects? (3 levels)

A

1) internal cashflow or risk free debt (issuing risky security is seen as a negative NPV event)
2) risky debt (lower borrowing cost than equity)
3) equity (manager believes market undervalues firm)

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15
Q

According to Heaton (2002), What happens to the forecasted cashflows of optimistic managers?

A

they are larger than they should realistically be, due to optimistic view on probability of returns and amount of yield

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16
Q

Objectively, according to Heaton (2002), if there is no informational asymmetry and prices are efficient, what is the additional cost of external financing? what are the implications of this?

A

there is no additional costs

optimistic managers perceive additional costs of external financing and may therefore pass up a positive NPV project due to including these none existent costs.

i.e. When ER(r)−i > 0, but EO(r)−i −CO(E) ≤ 0

17
Q

According to Heaton (2002), how is the problem of perceived costs of external funds eliminated?

A

Through FCF

More projects will be rejected by firms that do not have sufficient CF to finance them internally.

18
Q

According to Heaton (2002), what is the cost of FCF?

A

managers may take on neg NPV projects when optimistic: EO(r) > i > ER(r), if managers had needed to use external finance the bad investment would have been prevented EO (r ) − i − CO (E ) ≤ 0.

19
Q

According to Heaton (2002), how will managers will seek to reduce their reliance on external funds?

A

(i) retaining CF
(ii) avoiding high debt
(iii) cash flow risk management

20
Q

How can cost of FCF be overcome?

A
  • Introduction of outsiders (directors/chairman), make managers aware that their perceptions are not realistic (Kahneman and Lovallo 1993)
  • Strong managerial incentives and strong outside monitoring
21
Q

what does Stein (1987) discuss?

A

Managerial Myopia

22
Q

Stein (1987), what does it mean for corporate managers to behave myopically?

A

inflating current earnings at the expense of longer term benefits

23
Q

how do myopia and optimism differ?

A
myopia = behaviour
optimism = perception
24
Q

what does the Efficient Market Hypothesis imply about myopia?

A

markets can’t be fooled by inflating prices, therefore managers will not try lying

25
what does Jensen (1986) argue about myopia?
that it only becomes a problem when managers don't care enough about stock prices
26
does Stein (1987) agree with Jensen (1986) on myopia? what is his argument?
No, Stein claims the more concerned the managers are about stock prices, the worse the problem becomes.
27
According to Stein (1987), why would managers want to manipulate earnings shown on the stock market? (2) what are the consequences if the market is efficient?
- Stock market uses earnings to make a rational forecast of firm value - manipulate stockholders’ signals by pumping up earnings to raise projected firm value - In equilibrium, the market is not fooled by this signal jamming, i.e. firm borrows to inflate earnings, market backs out, because it recognises artificial earnings