CEOs with a rosy outlook of their company tend to view external funding as excessively costly and instead choose to fund current investments with the company’s existing cash balance, leading to 24% less cash on hand and lower funding levels for growth opportunities, according to new research.

In a study published Jan. 19 in the Journal of Corporate Finance, researchers found that an optimistic CEO believes that their firm’s equity is currently underpriced, a fact that will be mitigated as investors learn about the profitability of the company’s investments. Accordingly, an optimistic CEO delays raising external financing, as they expect the cost of external funding to decline.

Among CEOs, optimism, also referred to as overconfidence by the researchers, is defined in the study as an “upward bias in expectations of future outcomes,” compared to “rational” CEOs who take all available information into account and make decisions that benefit them most. Researchers considered CEOs to be optimistic if they held options that were more than 100% “in the money” — a term used in options trading that refers to an option with a strike price that has already been surpassed by the current stock price — at least once during their tenure. 

“If CEOs or top managers are not always rational, either they are making mistakes, or maybe they are not making mistakes — they just do not have the same objective that we assumed,” said Anand Goal, an associate professor at Stevens Institute of Technology and a co-author of the paper. “Or they may have some tastes, but for whatever reason, if their decision-making is not what we expect rational managers to do, then you should see some patterns.”

Using option-compensation data for firms from Standard and Poor’s ExecuComp database between 1992 and 2012, researchers created a dynamic model of the effect of CEO optimism on cash holdings. The researchers eliminated data for financial firms, utilities and regulated telephone companies, leaving them with 19,328 firm-year observations for 2,172 companies.

The main insight, Goel and his colleagues wrote, is that optimistic CEOs’ concerns about current financing constraints outweigh concerns about future financing, and they behave as if they face temporary financial constraints.

“They draw down heavily on liquidity reserves to meet contemporaneous investment needs and anticipate more generous external financing in the future after weathering a period of tight financial constraints,” the researchers wrote.

This can be a good thing, Goel said, if a company was holding too much cash to begin with, but, “More likely than not, they are keeping too little cash compared to what they should be holding.”

“So that means they might be giving up on some investment opportunities because they just do not want to hoard cash,” he said.

This effect is mitigated, however, among companies with multiple divisions that can transfer cash to other parts of the firm in need of funds.

Optimistic CEOs are also more likely to rely on lines of credit, which can provide liquidity to a company and allow it to invest in itself with more flexibility than external financing.

“So by relying on lines of credit, I do not hold costly cash, which I think is unduly costly,” Goel said. “But I can go back and tap funds from the line of credit as and when needed.”

Goel has published several other papers on how CEO behavior impacts corporate policy, such as how envious CEOs affect mergers and how overconfidence affects dividend policy.

The big unanswered question, Goel said, is whether CEO optimism can be definitively categorized as either good or bad overall.

“I mean, so far, it seems like … at least in a big segment of firms, having an optimistic CEO seems to be a good idea,” Goel said. “But we need to be more thorough in making sure that our result is robust.”

He added that he’s also interested in examining what causes people to become overconfident or optimistic, which could allow corporate boards to examine a candidate’s background and prior experience in order to evaluate their worldview.

“That is an area in which not just I, but many others are working,” Goel said. “People have looked at CEOs who came from military families, CEOs from families which immigrated to U.S. and came from countries which had economic recession. So how do these memories impact decision-making years after they’ve experienced these shocks?”

The major difficulty, he said, is that CEOs are not randomly assigned to firms, and so economists have to be careful when controlling for different variables.

“If you could randomly take two firms which are similar and throw an optimistic CEO in one and not an optimistic CEO in the other and look at the differences, then you could say, OK, which firm did better,” Goel said. “But that doesn’t happen randomly. The firms to which optimistic CEOs are assigned might be different from the firms to which non-optimistic CEOs are assigned.”

The study “Do CEO Beliefs Affect Corporate Cash Holdings?,” available online Jan. 19, 2021, from the Journal of Corporate Finance, was authored by Sanjay Deshmukh, DePaul University; Anand Goel, Stevens Institute of Technology; and Keith Howe, DePaul University.