Heaton, (2002) focuses on the behavioral approach explained in a simple corporate model to illustrate the implications of corporates free cash flow debate. In his article, Heaton reflects on the optimistic behavior of managers when evaluating the capital markets for their investments. Consequently, this behavior formulates the overinvestment-underinvestment tradeoff that is associated with the free cash flows. The tradeoff is depicted not to invoke agency cost theories and the asymmetry of market information. Optimistic managers are described to be utilitarian who anticipate overestimating future values of investments having in mind that the capital markets are underestimating them.
Apparently, there is a tendency of overestimating the firms projects, and chances arise they invest in non-returning projects. To illustrate such a financial investment phenomenon, Heaton uses a simple corporate financial model to depict how optimistic managers make their investment decisions. Additionally, the article sheds light on the cost-benefit analysis of free cash flow. Besides, the free cash flow has been revealed to be an alternative solution to this tradeoff in addition to external proxies, as well as, financial hedging and issuance of risk-free securities. Cases where foreign funds rely, managerial optimism has been depicted to have high chances of misleading the decisions made; whether to invest or not. However, Heatons model is based on information symmetric, consideration of a positive Net Present Valued projects, stability of security prices and neutrality in risk in the capital markets.
Situations that arise
Various situations arise with the tradeoff presented by the optimistic managers operating inefficient markets. However, the dominant ones are; that the encouraging managers have a strong believe that the capital markets underestimate the value of their risky securities. Apparently, this translates to a decline on the NPV of their externally-funded projects. On the other hand, the optimistic managers tend to overvalue their funded projects leading to high chances that they consider investing in negative NPV projects. Consequently, these two aspects bring the underinvestment-overinvestment tradeoff that has various investment and managerial implications.
First, the optimistic behavior makes it unclear whether the firms corporate culture may eliminate the administrative irrationality. Consequently, irrational managers (optimistic) may lower the expected utility of the firm in investing in large-risked projects. Apparently, optimism influences the free cash flow of business where its cost-benefit aspect is shaped by the trade-off and the asymmetric information approach. Optimistic managers believe that they have securities information that the markets do not have. Such an idea declines positive NPV opportunities at the expense that they are under-valued by the uninformed market.
On the other hand, the agency cost approach presented by Heaton (2002) identifies that free cash flow becomes costly when conflicts arise between the shareholders and the optimistic managers. In such cases, the managers anticipate retaining the free cash flows to increase managerial benefits while shareholder demands investment of such cash flows to enhance the value of the firm. Moreover, the undervaluation assumption of securities may influence the managers proposition on externally-funded projects. Consequently, chances arise where positive NPV externally-funded projects are declined because the cost is high. Such an idea gives the rationale for making use of internal free cash flow. The managerial optimism links costs and benefits of free cash flows on the availability of the investment opportunities and the level of confidence.
Possible solutions to the situations
Solving the underinvestment-overinvestment tradeoff brought by the optimistic managers appears ambiguous regarding the fact that the trading of the securities is influenced by external factors. Consequently, these factors behave in a probabilistic manner that becomes hard to predict. For instance, interest rates are hard to predict their certainty hence estimating the future discounted value becomes tricky. However, optimistic managers never want to be associated with losing; therefore, a few solutions have been suggested on how they can leverage such a financial tradeoff.
As optimism makes value estimation to be biased, Heaton suggests that solving the tradeoff, firms may opt the preference of risk-free securities that the risky debts and equity. The risk-free debts must be paid with all conditions. Such an idea depicts that if a risk-free debt has absolute cash flow of Y1 in time (T1) and uncertain cash flow (Y2) in time (T2) it becomes easy to make the investment. Optimistic managers will estimate Y2 to be a severe cash flow and determine it on the lower side. If Y1 + Y2 are greater than the initial capital of the investment (K), it will be easy to break the tradeoff and invest in such a project. In case Y1 + Y2 < K, now the managers may consider issuing of equity that is less risk as opposed to risk debts.
Heaton, (2002) argues that avoiding such biases, the firm may find to work and invest with what it can afford. Such an idea brings the light to the use of the firms free cash flows. Accordingly, these streams of funds eliminate the perceived costs of any external funds that the managers would have considered. Therefore, the benefits of free cash flow come in as managers would only consider funding a project on the basis of its NPV, if and only if the free cash streams are sufficient. Apparently, the use of these streams is not affected by the market factors such as information asymmetric, security interest rates and taxation. Therefore, optimistic managers have no chance to think of it; hence no tradeoff.
Lastly, avoiding external debts and retaining internal cash flows allow avoiding the tradeoff. Additionally, firms may consider applying risk management techniques to protect the cash flow of the business may be a possible solution. Risk management techniques allow efficient investment decisions and in such a case will offer more grounds to evaluate different projects to be invested. A firm may also consider hedging to protect the corporate cash flows. Such a strategy allows managers to avoid actual extreme costs of the external funds. Ideally, hedging protects the investment opportunities from such high marginal costs associated with foreign resources.
The best solution
According to the options mentioned above it may be impossible to avoid external factors such as market rates. Realistically, with the risk-free debts and future severe cash flow of the security (Y1 + Y2); chances are there even cash flow during T1 to be stumbled by the market or internal factors to the firm. Therefore, there is an element of risk that may be unavoidable making the solution not sufficient. An introduction of risk management techniques on free cash flows is more realistic, feasible and the best solution that solves this trade-off phenomenon. Risk management techniques such as payback period, NPV, Internal rate of return, Return on Investment, Cost/benefits ratio, sensitivity analysis; discounted payback and Multi-criteria analysis apply to solving this tradeoff. Accordingly, it allows a chance to include external proxies to determine how best to balance the free cash flows and any external finances in case they are considered (Brealey and Myers, 2006).
Reflexive analysis embraces the examination of the relationship between the researcher and the research, as well as, how the relationship affects the responses to any rising questions. Additionally, it sheds light to how meanings are produced within any given context meaning-making (Reynolds, 2001). Structurally, the reflexive analysis addresses the cause-effect relationship. Heaton, (2002) discusses the underinvestment-overinvestment tradeoff using assumptions that the optimistic managers make. To consider underinvestment, the managers feel that market has not information regarding its securities hence undervaluation may occur.
On the other hand, they tend to believe that their projects are well-off hence overestimate their future values. To examine this tradeoff, Heaton makes assumptions in that there is a simultaneous flow of security information, positive NPV projects are rationally considered, and security prices are stable. These aspects formulate his simple model depicting how optimistic managers forecast their future values that are driven by profit gains with no consideration of the external factors. The biased estimates cause the poor investment decisions because encouraging managers may select a positive NPV projects while on reality has negative NPV.
Conclusion and recommendation
Managerial optimistic behavior practices may lead to biased decisions that make firms invest in non-profitable projects. Bad cash flow forecasts will automatically induce a poor choice. As long as, the optimism behavior is there, the agency cost problem or the manager/shareholder problem will prevail. Additionally, the assumption that managers make for markets to have information asymmetry may not hold in most cases. Managers should realize that the prices and values for securities depend on their demand and supply that is influenced by the prevailing market interest rates. The optimistic tradeoff is highly solved by avoiding external finances and introduction of risk management techniques that give a chance for external proxies. Such methods evaluate projects regarding the prevailing real values as they are while foreign proxies allow identification of any mistakes done by the internal management for a better decision.
Brealey, R. A. and Myers, S. C.,(2006). Principles of Corporate Finance, Ninth Edition.
Heaton, J. B. (2002). Managerial Optimism and Corporate Finance. Financial Management, 31, 2, 33.
Reynolds, L. T. (2001). Reflexive Sociology: Working papers in the self-critical analysis. Rockport, TX: Rockport Institute Press.
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