The Impact of Ambiguity on Managerial Investment and Cash Holdings

Abstract

Standard finance theory suggests that managers invest in projects that, in expectation, produce returns that justify the use of capital. An underlying assumption is that managers have the information necessary to understand the distributional properties of the payoffs underlying the decision. This paper examines firm investment behavior when managers are likely to find it more challenging to develop expectations of payoffs, namely during periods of increased macroeconomic ambiguity. In particular, we examine how macroeconomic ambiguity -proxied by the variance premium (Drechsler, 2010) and the dispersion in forecasts of corporate profits from the Survey of Professional Forecasters (Anderson et al., 2009) -impacts managerial capital investment and cash holdings. Consistent with ambiguity theory, we find that macroeconomic ambiguity is negatively associated with capital investment and positively associated with cash holdings. These results are robust to alternative explanations related to risk, investor sentiment, and economic conditions. Moreover, consistent with recent theoretical real options literature, we find that ambiguity reduces the value of investment opportunities, while risk increases the value of such opportunities. Overall, these findings provide initial empirical evidence on the economic distinction between ambiguity and risk with respect to managerial investment and cash holdings. 1 IntroductionWithin a firm, the allocation of capital to its highest value use is one of the most important roles of a manager. The central determinant of successful capital allocation is the precision with which a manager is able to identify cash flow prospects and apply appropriate discount rates for the respective investment decisions. Typically, the investment literature assumes that managers know, or behave as if they know, the probability distributions of the cash flows and discount rates related to potential projects. In other words, although project payoffs are ex ante unknown, managers feel confident in their assessment of investment payoff probabilities.Recent theoretical work by Nishimura and Ozaki (2007), however, argues that managers facing a decision regarding irreversible investment may not always have complete confidence in their perceived payoff probability measures. As Nishimura and Ozaki (2007) state, managers "might think other probability measures perturbed from the original one are also possible." This uncertainty regarding investment payoff-characterized by a set of probability measures rather than a single probability measure-is defined as ambiguity, or Knightian uncertainty. 1 The intuition developed in Nishimura and Ozaki (2007) draws from the large theoretical and experimental literature on ambiguity (e.g., Ellsberg, 1961;Bewley, 1986;Gilboa and Schmeidler, 1989), which builds on Knight (1921). 2 The purpose of this paper is to examine the impact of ambiguity on managerial investment and cash holding decisions. The ambiguity literature suggests that, in the presence of ambiguity, 1 ...

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