Managerial overconfidence, moral hazard problems, and excessive life-cycle debt sensitivity

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6 Citations (Scopus)

Abstract

The effects of managerial overconfidence on financing decisions and firm value are analyzed, given that investors face managerial moral hazard. Two cases are considered. In the first case, the manager may have an incentive to exert an inefficiently low level of effort in running the business ('managerial shirking'). The manager may issue high debt as a commitment device (the increase in expected financial distress drives him to a higher effort level). An overconfident manager overestimates his ability, and underestimates financial distress costs. Therefore, the first model predicts a positive relationship between overconfidence and debt. However, the effect of overconfidence on firm value is ambiguous, and depends on which factor (the positive effect of higher effort, or the negative effect of higher debt and higher expected financial distress) dominates. In the second case, the manager has an incentive to use free cash flow to invest in a new pet project that may be value-reducing (the free cash flow problem). In contrast to the first case, overconfidence may result in a decrease in debt (the rational manager knows that the new project is value-reducing and uses high debt to commit not to invest in it, while the overconfident manager perceives the new project as valueincreasing, and reduces debt in order to make the investment). Again, the effect of overconfidence on firm value is ambiguous, since a project that may have been value-reducing under a rational manager may indeed be valueincreasing under an overconfident manager, as the overconfident manager exerts higher effort. The analysis is concluded with a conceptual model of "excessive life-cycle debt sensitivity due to managerial overconfidence" not previously explored in the literature.

Original languageEnglish
Pages (from-to)35-42
Number of pages8
JournalInvestment Management and Financial Innovations
Volume6
Issue number3
Publication statusPublished - 2009

Keywords

  • Behavioural corporate finance
  • Life-cycle debt
  • Moral hazard
  • Overconfidence

ASJC Scopus subject areas

  • Business and International Management
  • Accounting
  • Finance
  • Economics and Econometrics
  • Strategy and Management

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