Is Cash More Valuable In The Hands Of Overconfident CEOs?
WHU – Otto Beisheim School of Management
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Cyprus University of Technology; University of Durham
University of Surrey – Surrey Business School
November 17, 2015
We investigate whether and how CEO overconfidence affects the value of cash. Cash is more valuable when firms are managed by overconfident CEOs. Economically, having an overconfident CEO on board increases the value of $1.00 cash holding by an additional amount of $0.49. This effect concentrates among firms that exhibit risky growth opportunities and are financially constrained or have high hedging needs. Additional analysis shows that cash holdings allow overconfident CEOs to increase future market share relative to industry rivals. Overall, our findings suggest that cash enables overconfident CEOs to exploit risky growth opportunities and improve product market performance.
Is Cash More Valuable In The Hands Of Overconfident CEOs? – Introduction
Over the last decades, US firms have accumulated increasingly more cash through time (Bates, Kahle, and Stulz (2009)). Cash stockpiling became even more popular under the recent financial crisis, highlighting the importance of a liquid balance sheet for firm performance (Frésard (2010)). Starting from the pioneering works of Faulkender and Wang (2006) and Pinkowitz, Stulz, and Williamson (2006), numerous studies have analyzed the value of cash holdings.1 The bottom line of these studies is that the value of cash is essentially driven by firm’s financial constraint status, its growth opportunities, and the quality of its governance structure. Our study builds upon and extends this literature by proposing that the value of cash is also affected in certain circumstances by managerial traits. The managerial trait we focus on is overconfidence, and we provide robust evidence that cash is relatively more valuable for firms managed by overconfident CEOs. This positive value effect concentrates among firms that exhibit risky growth opportunities and are financially constrained.
Our overconfidence story is based on the notion that the value of cash depends on the difference between the CEO and the market beliefs about the value of the firm. Overconfident CEOs tend to overestimate their firm’s future cash flows and hence to perceive that their firms are undervalued by the market (Malmendier and Tate (2005) and Malmendier, Tate, and Yan (2011)). This may lead them to avoid external finance, thus relying more on internal funds to finance their investment opportunities (Malmendier and Tate (2005) and Malmendier, Tate, and Yan (2011)).2 Additionally, Griffin and Tversky (1992) theoretically argue that people tend to be more overconfident about their performance on hard rather than easy tasks, which induces them to be attracted by risky and challenging growth opportunities (Hirshleifer, Low, and Teoh (2012)). This implies that, for firms run by overconfident CEOs, cash savings from operating cash flows will help the firm to better exploit growth opportunities, which are expected in turn to affect positively the value of cash holdings.3 Therefore, we argue that given the costly external financing view, cash is more valuable in firms managed by overconfident CEOs, because additional cash allows them to make risky growth investments which they might otherwise be passed over.
We begin our empirical analysis by following the approach of Almeida, Campello and Weisbach (2004) – who have shown that financially constrained firms save relatively more cash out of their operating cash flows – and investigate the cash flow sensitivity of cash holdings for firms with overconfident and non-overconfident CEOs. Interestingly, we find that, controlling for investment and financing activities, only firms managed by overconfident CEOs display statistically significant positive cash flow sensitivity of cash, consistent with the precautionary motive to hold cash in order to continue to invest in positive NPV projects during periods when external finance is costly.4 Further, this finding is in line with their preference to rely on internal financing. Additionally, having established that overconfident CEOs have the firepower offered by cash savings, it motivates us to raise the questions of whether cash is relatively more valuable in their hands, i.e., whether managers use cash in a way that increases the value of the firm and, if yes, through which channel?
We therefore proceed to our main analysis and examine the impact of managerial overconfidence on the value of cash using the valuation framework of Faulkender and Wang (2006). We generate estimates of the additional value the market incorporates into equity values that results from changes in the cash position of firms over the fiscal year. We show that CEO overconfidence is associated significantly with an increase in the marginal value of an extra dollar of cash. In economic terms, having an overconfident CEO on board increases the value of $1.00 cash holding by an additional amount of $0.49 relative to a firm run by a non-overconfident CEO. We provide various additional checks and confirm the robustness of our main finding. In particular, we show that our result is not due to non-random CEO-firm matching, CEOs’ general managerial ability, and overconfident CEOs just being more risk-tolerant. Our finding is also robust to the use of alternative overconfidence proxies. Finally, in further analysis, we also control for the quality of the firm’s governance structure, and our main result is insensitive to this alteration.
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