Topic 9 - Managerial Optimism and Myopia

Question 1

When are managers taken to be optimistic?

Answer 1

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

Question 2

What is Free cash flow?

Answer 2

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

Question 3

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

Answer 3

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.

Question 4

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

Answer 4

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.

Question 5

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

Answer 5

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.

Question 6

What is Heaton (2002) view on FCF?

Answer 6

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

Question 7

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

Answer 7

• (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

Question 8

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

Answer 8

• 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.

Question 9

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

Answer 9

(i) the level of managerial optimism;

(ii) the investment opportunities available to the firm.

Question 10

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

Answer 10

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

Question 11

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?

Answer 11

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

Question 12

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

Answer 12

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)

Question 13

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

Answer 13

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

Question 14

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

Answer 14

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)

Question 15

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

Answer 15

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

Question 16

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?

Answer 16

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

Question 17

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

Answer 17

Through FCF

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

Question 18

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

Answer 18

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.

Question 19

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

Answer 19

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

Question 20

How can cost of FCF be overcome?

Answer 20

• 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

Question 21

what does Stein (1987) discuss?

Answer 21

Managerial Myopia

Question 22

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

Answer 22

inflating current earnings at the expense of longer term benefits

Question 23

how do myopia and optimism differ?

Answer 23

myopia = behaviour
optimism = perception

Question 24

what does the Efficient Market Hypothesis imply about myopia?

Answer 24

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

Question 25

what does Jensen (1986) argue about myopia?

Answer 25

that it only becomes a problem when managers don’t care enough about stock prices

Question 26

does Stein (1987) agree with Jensen (1986) on myopia? what is his argument?

Answer 26

No, Stein claims the more concerned the managers are about stock prices, the worse the problem becomes.

Question 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?

Answer 27

• 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