Managerial Optimism and Corporate Investment Some Empirical Evidence

Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan Yueh-hsiang Lin Shing-yang Hu Ming-shen Chen Department of Finance National Taiwan University Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

2 Managers will be optimistic!!! • Psychology literature explains about managers’ upward bias in the assessment of future outcomes as following reasons: § Managers have a great deal of control over their firms’ performance. § Managers appear highly committed to the firm’s performance because their personal wealth, reputation, and employability are highly dependent on it. § Better-than-average effect: Managers overstate the value of the project relative to the average of the projects introduced by other managers to the market. Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

3 The impact of managerial optimism on corporate decisions: literature review • Takeover: winner’s curse (e. g. , Roll, 1986). • Dividend: increase (e. g. , De. Angelo, and Skinner, 1996). • Financing: higher leverage and a pecking order. (e. g. , Hackbarth, 2002). • Choice for managers: hiring only moderately optimistic managers is less expensive for shareholders (e. g. , Gervais, Heaton, and Odean, 2002). Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

4 The impact of managerial optimism on investment decision • Heaton (2002): § Managerial optimism results in either underinvestment or overinvestment. § With sufficient internal funds, optimistic managers Øovervalue the projects Øinvest in negative NPV projects. § Once internal funds are exhausted and firms are constrained, optimistic managers Øperceive the market as undervaluing their firms, Øare reluctant to issue new equity Øreject positive NPV projects. Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

5 The impact of managerial optimism on investment decision: (Cont’d) • Malmendier and Tate (2004): § Construct measures of managerial optimism using CEO’s personal portfolio of the firm’s options and stockholdings. § In American companies, managerial optimism affects the investment-cash flow sensitivity. Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

6 Objective • This paper provides: § a robustness check of Heaton’s (2002) model. § an alternative measure of managerial optimism from management earnings forecasts. ØEarnings forecasts are prevalent because they are allowed and legislatively regulated in most countries. ØThe measure constructed from earnings forecasts could be similarly established in these countries. Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

7 Sample • Companies listing on the Taiwan Stock Exchange (TSE) and the Over the Counter (OTC) during the period from 1985 through 2002 from Taiwan Economic Journal database (TEJ). Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

8 The Managerial Optimism Measure • The context of the measure involves management forecasts for earnings before tax. • For each forecast, define § forecast error as the forecast value minus the actual value. § a forecast as upwardly-biased if the forecast error is positive. • The forecasts in database don’t record the publisher, we assume that the CEO has the final say in the whole management team, and the forecasts are made by CEOs. Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

9 The Managerial Optimism Measure (Cont’d) • A CEO’s optimism in assessing future outcome is likely to result in upwardly-biased forecasts: § Classify whether a CEO is optimistic if he/she has at least two forecasts. § Consider a CEO to be optimistic if there are more upwardlybiased forecasts than downwardly-biased forecasts during the CEO’s tenure. Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

10 The Managerial Optimism Measure (Cont’d) • Since CEOs may also have other incentives to bias their forecasts, from the sample we remove forecasts that may be affected by incentive effects such as stock offerings, financial distressed, and insider trading: § Example: a firm conducts an equity offering within 12 months of the forecast. • Examine only the last forecast for a fiscal year: § Managers will minimize their manipulation in the last forecasts to avoid being punished by the regulatory agency when the forecasts are proven false. Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

11 Proportion of Optimistic CEOs

12 Testable Hypothesis • In constrained firms, the investment-cash flow sensitivity is larger for optimistic managers than non-optimistic managers. § Optimistic managers invest more than non-optimistic managers do when cash flows are ample. § Optimistic managers invest less than non-optimistic managers do once internal funds are exhausted and firms are constrained. Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

13 Empirical model • Test: using a constrained subsample to run the regression: (1) § where I is the investment, § C is the cash flow from operation, § Q is the ratio of market value to book value, and § O is the dummy variable which is 1 if the manager is classified optimistic and 0 if he/she is not (i. e. the optimism measure). • Prediction: is positive. • To avoid possible distortion caused by firm size we normalize I and C by the beginning total assets. Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

14 The identification of the extent of firms’ constraints • To ensure that whether a firm is constrained is properly identified, we follow the literature of “financing constraints” to use several classifications. § dividend payout § interest coverage § Firm characteristics tied to problems of asymmetric information or agency: size, age, industry, group affiliation, ownership concentration, or cash flow rights of the controlling shareholder. Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

15 The identification of the extent of firms’ constraints (Cont’d) • For each characteristic except industry and business group affiliation § rank the firms by average of the characteristic in the sample period § split sample firms into two groups: one is more constrained and the other less constrained • Example: smaller 50% firms are identified more constrained and larger 50% firms less constrained. Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

16 Main results: OLS regressions of investment on cash flow and optimism measure

17 Robustness • The results are similar under the following alternative scenarios. § The forecasts are made by Presidents of the Board or CFOs. § Controlling yearly fixed effects or random effects. § Controlling agency or information asymmetry problems. § The optimism measure is defined Øby only mandatory forecasts or only voluntary forecasts. Øby only forecasts prior to the investment period in the regression. Øby CEOs’ shareholdings of the company. Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

Conclusions • We provide empirical evidence of an alternative source from which corporate decisions are impacted: managerial optimism plays a role in their investment decisions. § In Taiwanese companies, optimistic managers exhibit higher investment-cash flow sensitivity than do nonoptimistic managers. THE END Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan 18