1 Effect of Managerial overconfidence, asymmetric Info, and moral hazard on Capital Structure Decisions. Rational Corporate Finance. -Capital Structure:

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Presentation transcript:

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 mgrs 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:

6 Good mgr issues Debt, bad mgr issues equity. Both mgrs issue equity.

7 Proposition 1. a)If b) c) Overconfidence leads to more debt issuance.

8 Overconfidence and Moral Hazard Firms project: 2 possible outcomes. Good: income R. Bad: Income 0. Good state Prob: True: Overconfidence: True success prob:

9 Managers Perceived Payoffs

10 Optimal effort levels

11 Effect of Overconfidence and security on mgrs effort Mgrs effort is increasing in OC. Debt forces higher effort due to FD.

12 Managers perceived Indirect Payoffs

13 True Firm Value

14 Effect of OC on Security Choice Manager issues Equity. Manager issues Debt.

15 Effect of OC on firm Values

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.

17 Results (continued). If 2 cases: Optimal OC: Or Optimal OC:

18

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.