1

Effect of Managerial overconfidence, asymmetric Info, and moral hazard on Capital Structure Decisions.

Rational Corporate Finance.

-Capital Structure: moral hazard + asymmetric info.

-Debt reduces Moral Hazard Problems

-Debt signals quality.

Behavioral Corporate Finance.

-managerial biases: effects on investment and financing decisions

-Framing, regret theory, loss aversion, bounded rationality.

-OVERCONFIDENCE/OPTIMISM.

2

Overconfidence/optimism

• Optimism: upward bias in probability of good state.

• Overconfidence: underestimation of asset risk.

• My model =>

• Overconfidence: overestimation of ability.

3

Overconfidence: good or bad?

• Hackbarth (2002): debt decision: OC good.

• Goel and Thakor (2000): OC good: offsets mgr risk aversion.

• Gervais et al (2002), Heaton: investment appraisal, OC bad => negative NPV projects.

• Zacharakis: VC OC bad: wrong firms.

4

Overconfidence and Debt

• My model: OC => higher mgr’s effort (good).

• But OC bad, leads to excessive debt (see Shefrin), higher financial distress.

• Trade-off.

5

Behavioral model of overconfidence.

Both Managers issue debt:

.ˆ,ˆ qqpp

.)ˆ1(ˆ2

ˆ bpqp

IpRpM g

.)ˆ1(ˆ2

ˆ bqqp

IqRqM b

6

Good mgr issues Debt, bad mgr issues equity.

.)ˆ1(ˆ

ˆ bpIp

pRpM g

.ˆ

ˆ Iq

qRqM b

Both mgrs issue equity.

,ˆ2

ˆ Iqp

pRpM g

.ˆ2

ˆ Iqp

qRqM b

7

Proposition 1.

a) If

b)

,)ˆ1()ˆ1()(

)(ˆbpbqI

qpq

qpq

}.{ DSS bg

,)ˆ1()(

)(ˆ)ˆ1( bpI

qpq

qpqbq

}.,{ ESDS bg

c) ,)(

)(ˆ)ˆ1()ˆ1( I

qpq

qpqbpbq

}.{ ESS bg

Overconfidence leads to more debt issuance.

8

Overconfidence and Moral Hazard

• Firm’s project: 2 possible outcomes.

• Good: income R. Bad: Income 0.

• Good state Prob:

• True:

• Overconfidence:

• True success prob:

].1,0()( eP .0.0

.eP

9

Manager’s Perceived Payoffs

.)ˆ1()(ˆˆ 2 IPDebPDRPM D

.)1(ˆˆ 2 IPReRPM E

10

Optimal effort levels

2

))((*

bDReD

2

))((*

DReE

11

Effect of Overconfidence and security on mgr’s effort

• Mgr’s effort is increasing in OC.

• Debt forces higher effort due to FD.

12

Manager’s perceived Indirect Payoffs

bIDbDRbDR

M D

2

))((

4

)()(ˆ22

IDDRDR

M E

2

))((

4

)()(ˆ22

.2

)(

4

))(2()(ˆ22

bbDbDRb

M D

13

True Firm Value

.2

))()(()( b

bRbDRbbRPV DD

.2

))((

RDR

RPV EE

14

Effect of OC on Security Choice

024

))(2()0(ˆ

222

bbDbIRb

M D

0ˆ

DM

.0)(ˆ CDM

],,0[ C

,C

Manager issues Equity.

Manager issues Debt.

15

Effect of OC on firm Values

.2

))()(()( b

bRbDRV CD

bDRRbDbbR

VD

2

)()2)(( 22

.2

)()0(

2

RDR

VE

16

Results

• For given security: firm value increasing in OC.• If• Firm value increasing for all OC: OC good.• Optimal OC: • If • Medium OC is bad. High OC is good.• Or low good, high bad.

,0)( CDV

,0)( CDV .* max

17

Results (continued).

• If

• 2 cases: Optimal OC:

•

• Or Optimal OC:

,0)( CDV

.* max

.* C

18

Effect of Overconfidence on Firm Value

-600

-400

-200

0

200

400

600

800

1000

1200

0 0.1 0.2 0.3 0.4 0.5

Overconfidence

Val

ue

Effect of Overconfidence on Firm Value

-2000

-1500

-1000

-500

0

500

1000

1500

2000

2500

1 2 3 4 5 6 7 8 9 10

Overconfidence

Val

ue

Effect of Overconfidence on Firm Value

-2000

-1500

-1000

-500

0

500

1000

1500

2000

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

OverconfidenceV

alu

e

19

Conclusion.

• Overconfidence leads to higher effort level.

• Critical OC leads to debt: FD costs.

• Debt leads to higher effort level.

• Optimal OC depends on trade-off between higher effort and expected FD costs.

20

Future Research

• Optimal level of OC.

• Include Investment appraisal decision

• Other biases: eg Refusal to abandon.

• Regret.

• Emotions

• Hyperbolic discounting

• Is OC exogenous? Learning.