Managerial Optimism and Corporate Investment: Some Empirical Evidence from Taiwan

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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

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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

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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., DeAngelo, DeAngelo, 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).

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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

overvalue the projects

invest in negative NPV projects.

 Once internal funds are exhausted and firms are constrained, optimistic managers

perceive the market as undervaluing their firms, are reluctant to issue new equity

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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

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6 Objective

• This paper provides:

 a robustness check of Heaton’s (2002) model.

 an alternative measure of managerial optimism from management earnings forecasts.

Earnings forecasts are prevalent because they are allowed and legislatively regulated in most countries.

The measure constructed from earnings forecasts could be similarly established in these countries.

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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).

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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

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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 upwardly-biased forecasts than downwardly-upwardly-biased forecasts during the CEO’s tenure.

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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.

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11

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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

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13 Empirical model

• Test: using a constrained subsample to run the regression:

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 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.

6



it i it it it i it it it C Q O C Q C O I  ₁  ₂  ₃ _₁  ₄  ₅ _₁  ₆ 

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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.

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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.

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16

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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

by only mandatory forecasts or only voluntary forecasts.

by only forecasts prior to the investment period in the regression. by CEOs’ shareholdings of the company.

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18 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 non-optimistic managers.