As experiments have shown, people in general are optimistic. In a classic study by Neil Weinstein in 1980, undergraduates were asked to rate how likely various life events were to happen to them, relative to their classmates. The result: students systematically thought that good events were more likely to happen to them, while bad events were more likely to happen to other students.
But how do seasoned executives think? Shefrin has replicated Weinstein’s test with his students, from undergrads to executive MBA candidates — “age 35 to 55, all with at least 10 years of management experience. Some are CEOs, CFOs, VPs of marketing.” The outcome? Executive MBA students are just as optimistic as undergrads — “except a little more so,” says Shefrin.
Managerial optimism can result in all kinds of flawed and risky decisions. But it may also have fundamental implications for what a company does with its free cash flow. J.B. Heaton, a partner at Chicago law firm Bartlit Beck Herman Palenchar & Scott LLP who holds a Ph.D. in finance from the University of Chicago, argues that managerial optimism provides a better guide to the problem of free cash flow than rational — but conflicting — notions of agency costs and asymmetric information.
According to the asymmetric-information approach, free cash flow is good. That’s because a company’s securities are typically undervalued, since managers have information that the market doesn’t. If so, then managers assumed to be loyal to shareholders will be reluctant to fund even positivenet present value projects by issuing more undervalued securities. Without free cash flow on hand, they will underinvest.
But this scenario conflicts with the rational agency-cost approach, which holds that free cash flow is bad. Why? Because managers are assumed to place their interests above shareholders’ and will invest in projects that boost their power and compensation, even if those projects have negative NPV. With free cash flow on hand, managers will overinvest.
Heaton’s model assumes that managers are neither loyal nor disloyal, but optimistic. Managerial optimism explains both underinvestment and overinvestment, depending on a company’s situation, and determines what should be done with free cash flow.
“In a company with generally marginal investment opportunities, managers are going to perceive that the opportunities are better than they are, and that means they’re going to think some bad projects are good projects,” says Heaton. At the same time, because they’re optimistic, managers will think the company’s securities are undervalued and won’t want to issue more. “So if they have extra cash lying around, they’re going to [overinvest],” says Heaton. “This suggests that if you have a company that is declining and doesn’t have a good set of investment opportunities, you want to tie their hands” by disgorging cash.
What if a company does have good investment opportunities? Again, optimistic managers will be concerned about issuing undervalued securities. Such companies want to have extra cash on hand, because without it, managers will underinvest.