Managerial reputation and corporate investment decisions - Corporate Investments Special Issue

Financial Management (Financial Management Association), Summer, 1993 by David Hirshleifer

2. Resolution Preference

(i) Putting Your Best Foot Forward. On an interview or a date, one always puts one's best foot forward. And although the saying doesn't mention it, this is the same as putting one's worst foot backwards. A project manager should do likewise. Thus, other things equal, if he expects good news to arrive (he may not be sure), he should try to advance the date at which that news will arrive. If he expects bad news, he should delay resolution of the project. This "putting your best foot forward" effect is an example of resolution preference, because the manager wants to shift resolution of uncertainty about the project forward or back (see Hirshleifer and Chordia |22~).

(ii) Risk Avoidance. If the manager dislikes personal risk, then there is an advantage to deferring resolution of uncertainty. Even for a good manager, there is an appeal to not being judged until ten years after retirement (as is suggested by the Roger Smith quote at the beginning of this article). By deferring the resolution of uncertainty, the manager temporarily maintains his reputation at the current level, and reaps the rewards at the current level. His current reputation is based on the current assessment of his ability. Deferred resolution makes his lifetime income more certain than if his reputation and pay were to jump up or down with an immediate news event.

3. Mimicry and Avoidance

If people expect a high-quality firm to undertake ambitious investments, then a low-quality firm can try to mimic. Consequently, a high-quality firm may be led to exaggerate those investments that are difficult or costly for low-quality firms to mimic. Trueman |47~ has pointed out that firms with low-quality investment opportunities may over-invest in order to seem to be firms with high-quality investments. Firms with high-quality investments also invest too much, in order to avoid being identified with the lower-quality firms! All firms are forced to overinvest. Since everyone knows this, they are not actually fooling anyone by doing so. But if a firm were to invest at the lower scale that is optimal for shareholders, investors would not give it any credit for doing so. Instead, they would assume that the firm had very poor investment opportunities.

Even if the investment choices are not visible to financial markets (such as expenditures on customer service and maintenance), mimicry and avoidance can be important. These will still occur, because the consequences of the investment decision (e.g., how favorable early news events are, or how early or later uncertainty about the project is resolved) are visible.

B. How Reputational Pressures Interact

Visibility bias and resolution preference should be viewed as the more fundamental management pressures, with mimicry and avoidance acting as a modifier. For example, suppose that some firms (efficient organizations) can provide hidden service to customers more effectively than others (inefficient organizations). For either type of firm, visibility bias leads to a temptation to secretly cut costs by reducing the quality of service. This boosts current net cash flows, and the long-run cost to the firm is not immediately visible. Suppose, however, that there is a positive probability that customer dissatisfaction will be discovered early by analysts and publicized widely. Then an efficient organization may maintain a superb level of service in order to demonstrate its high efficiency. If mimicry is too costly, an inefficient firm may still have low levels of service. On the other hand, the inefficient firm may also maintain customer service in order to avoid appearing even worse than it really is.