The effect of Managerial Overconfidence, asymmetric information, and moral

hazard on capital structure decisions.

Abstract

We examine the combined effects of managerial overconfidence, asymmetric

information and moral hazard problems on the manager’s choice of financing
(debt or equity). We demonstrate the following: a) in the asymmetric information
model, overconfidence is unambiguously bad. It induces excessive use of welfare-
reducing debt, b) in the moral hazard model, the effect of overconfidence is
ambiguous. It has a positive effect by inducing higher managerial effort. However,
it may lead to excessive use of debt and higher expected bankruptcy costs.
Overall, we contribute to the debate on managerial overconfidence by
demonstrating that managerial overconfidence is not necessarily bad for
shareholders.

1
I. Introduction

Since the seminal work of Miller and Modigliani (1958), much research effort has
been directed at understanding firms’ capital structure and investment decisions and
the corresponding effects on firm value. Until recently, the standard approach was to
assume rationality of managers and investors. For example, a large body of research
exists examining the role of security signalling in the face of informational
asymmetries in a rational framework (eg Leland and Pyle 1977, Ross 1977, Myers
and Majluf 1984). Another strand of research examines the use of capital structure to
mitigate agency problems (Jensen and Meckling 1976, Grossman and Hart 1982,
Jensen 1986, Dewatripont and Tirole 1991, Fairchild 2003). This approach assumes a
principal-agent problem based on selfish managerial rationality.
Recently, research in corporate finance has begun to recognise that the decisions of
managers and investors may be affected by behavioral biases. One strand of this
research has focussed on the issue of investor irrationality in financial markets, taking
managerial rationality as given. A second, less-investigated, area of research analyses
the corporate finance decisions of irrational managers, taking the rationality of
investors as given. For example, studies have analysed the implications of managerial
irrationality in capital structure (Heaton 2002, Shefrin 1999, Hackbarth 2002), and
capital budgeting decisions (Statman and Caldwell 1987, Gervais et al 2003, and
Shefrin 1999). By way of contrast, Stein (1996) analyses the combined effects of
managerial rationality and investor irrationality on optimal capital budgeting methods.

Rational Capital Structure Decisions: agency costs and signalling.

The seminal work on rational capital structure decisions in the face of agency
problems was undertaken by Jensen and Meckling (1976). They considered a model
in which a self-interested manager could divert company funds for consumption of
vale-reducing private benefits. Increasing the debt level (and reducing outside equity)
aligned the manager with the investors by increasing the manager’s personal equity
stake in the firm, hence reducing his incentives to take private benefits.
Jensen (1986) considered self-interested managers’ incentives to waste free cash flow
on empire-building, value-reducing, projects. Increasing debt commits managers to
paying out to debt holders, hence reducing the free cash flow problem.
Grossman and Hart (1982), Dewatripont and Tirole (1991), and Fairchild (2003a)
recognised the disciplining role of debt. In the Grossman and Hart model, the
manager can divert cash flows for investment in private benefits, while in the two
latter models, managers do not like exerting effort, and so have an incentive to
‘slack’. If debt holders are not paid, they can force the firm into bankruptcy. This
provides an incentive for managers to increase effort level, increasing firm value. An
interesting implication of these models is that managers may voluntarily wish to issue
high levels of debt in order to commit to higher effort levels and high firm value. This
is because, in an efficient capital market in which rational investors pay a fair price
for their investments, existing equity holders, including management, gain all of the
positive net present value from an investment.
Another area of research, based on rationality, examines the signalling role of debt
and equity when managers have more information about the firm than investors. For
example, Ross (1977) considers the signalling role of debt. He develops a model
consisting of two possible managerial types; high ability and low ability. The market
cannot distinguish between these types, and, in the absence of any signal, would price

2
the firm’s equity at the ‘average’ value. In Ross’s model, the managers are rewarded
in line with equity values. Furthermore, debt carries the threat of bankruptcy if debt
holders are not paid. Since the good manager is confident that he can repay the debt
holders, while the bad manager is not, the good manager is able to separate from the
bad manager by issuing debt, while the bad manager issues equity. Hence, debt
provides a signal of the manager’s confidence in his ability.
Myers and Majluf (1984) consider the signalling role of equity. Similarly to Ross,
they consider a manager who has more information than investors about the future
prospect of the firm. Specifically, the manager receives good or bad news in advance
of investors about the firm’s future income. In the absence of a signal, investors
believe that good or bad news arrives with equal probability. Therefore, they price the
firm at an average value. If the manager knows that good news is coming, he will
avoid issuing undervalued equity, since this will dilute his equity stake. If he knows
that bad news is coming, he will attempt to ‘beat the market’ by issuing overvalued
equity. However, by issuing equity, the manager will signal his knowledge of the bad
news to rational investors, and the share price will fall. This is termed the Myers-
Majluf mispricing problem.
Hence, Myers and Majluf derive a pecking order of finance, in which firms will first
use retained earnings to invest in new projects (so that they can avoid the mispricing
problem associated with external capital markets). Secondly, they will use debt.
Finally, they will use equity as a last resort.

Managerial Irrationality and Corporate Financing Decisions.

Recent behavioral research in corporate finance has attempted to analyse the

implications of agents’ irrationality. Investor irrationality has been used to explain
stock price bubbles (Blanchard and Watson 1982), and market over- and under-
reaction (Barberis et al 1998, Daniel et al 1998). A second, less-investigated, area of
research analyses the corporate finance decisions of irrational managers, taking the
rationality of investors as given. For example, studies have analysed the implications
of managerial irrationality in capital structure (Heaton 2002, Shefrin 1999, Hackbarth
2002), and capital budgeting decisions (Statman and Caldwell 1987, Gervais et al
2003, and Shefrin 1999). By way of contrast, Stein (1996) analyses the combined
effects of managerial rationality and investor irrationality on optimal capital
budgeting methods.

There are, of course, many definitions of irrationality. Some authors analyse the
effects of bounded rationality on decision-making (Mattson and Weibull 2002). In
prospect theory, (Kahneman and Tversky 1979; Tversky and Kahneman 1992) and
regret theory (Bell, 1982; Loomes and Sugden 1982), agents tend to place too much
weight on high probability gambles. This induces risk averse behavior over positive
income domains, but risk-seeking behavior over negative ranges. At the extreme of
behavioral analysis, we can consider the role of emotions in decision making
(Loewenstein 1996, Elster 1998, Thaler 2000, Stanovitch and West 2000).

Overconfidence.

We focus on one particular behavioral bias, namely managerial overconfidence. Our

model examines the combined impact of agency problems, informational
asymmetries, and overconfidence on the manager’s financing decisions. In this

3
section, we provide a brief review of the existing research into managerial
overconfidence. In the next section, we focus on the research into the effect of
overconfidence on capital structure decisions, and compare our model with two
particularly relevant papers (Heaton 2002 and Hackbarth 2002).
Increasingly, researchers are recognising that the bias of overconfidence may play a
significant role in managers’ financing and investment decisions (for example;
Kahnemann and Lovallo 1993, Shefrin 1999, Goel and Thakor 2000, Malmandier
and Tate 2001, Heaton 2002, Gervais, Heaton and Odean 2003, Hackbarth 2004).
Heaton (2002) cites the psychological research (eg, Weinstein 1980, March and
Shapira 1987) that supports the view that people are over-optimistic or overconfident.
This research demonstrates that agents tend to be more optimistic about outcomes a)
that they believe that they can control, and b) to which they are highly committed.
Both findings support the view that managers may be overconfident about the success
of their ventures.
The behavioral corporate finance literature often draws a distinction between
optimism and overconfidence. Optimism is usually defined as a subjective
overvaluation of the likelihood of favourable future events, while overconfidence
relates to underestimation of the risk or variance of future events (see, for example,
DeLong et al 1991, Goel and Thakor 2000). However, in much of the literature, the
terms are used interchangeably. In our work, overconfidence refers to the manager’s
overestimation of his ability to affect the successful outcome of his firm’s projects.
Researchers have considered the desirability of managerial overconfidence in capital
budgeting and capital structure decisions. The research thus far provides mixed
results. Kahnemann and Lovallo (1993) argue that managerial optimism may lead to
managers making “bold forecasts” regarding prospective projects, while at times
making timid choices due to risk aversion. In Goel and Thakor’s (2000) tournament
model of managerial promotion to executive positions, managers become
overconfident in order to increase their chances of success. This is beneficial for
shareholder wealth, since it offsets some of the manager’s risk aversion. Gervais et al
(2002) examine whether managerial optimism and overconfidence can offset sub-
optimal risk taking in capital budgeting decisions due to managerial risk-aversion.
They find optimism is desirable, but overconfidence exacerbates the problem.
Heaton (2002) argues that overconfidence leads to managers overestimating the net
present value of new investment projects. Therefore, they will invest in negative NPV
projects that they mistakenly believe to be positive NPV. Hence, overconfidence is
value-reducing. Similarly, Malmandier and Tate (2004) argue that overconfidence
may result in corporate investment distortions. Overconfident managers view external
funds as unduly costly. Therefore, they overinvest when they have abundant internal
funds, and they underinvest when they require external financing.
Zacharakis and Shepherd (2001) consider the investment appraisal process of venture
capitalists. They argue that, due to time and resource constraints, VCs may be
overconfident in their ability to evaluate business plans. In particular, they may
overestimate the bad signals that they receive, and this may lead to excessive rejection
of potentially good projects.

Overconfidence and Capital Structure decisions.

In Shefrin’s (1999) survey of behavioral finance, he states that overconfidence may

induce a manager to adopt an overly-heavy sub-optimal debt-laden capital structure.
However, very little rigorous theoretical work has been carried out to analyse the

4
desirability of overconfidence in relation to financing decisions. We address this by
considering the relationship between managerial overconfidence, asymmetric
information, and moral hazard. In particular, we develop two models. In our first
model, we consider the combined effects of overconfidence and asymmetric
information on financing decisions (abstracting from moral hazard problems). In our
second model, we consider the combined effects of overconfidence and moral hazard
(with symmetric information). In contrast to the existing literature, we demonstrate
that the relationship between overconfidence and firm value is ambiguous.
Heaton (2002) analysed the effect of overconfidence on financing decisions in the
absence of asymmetric information or moral hazard problems. Since the manager is
overconfident, he believes that the market undervalues his equity. Therefore, the
Myers-Majluf mispricing problem exists. That is, the manager may pass up a positive
NPV project, in which case, free cashflow is beneficial. However, due to managerial
overconfidence, the manager may take negative NPV projects that he mistakenly
believes to be positive NPV. Now free cashflow is harmful (as in Jensen 1986).
Hence, Heaton argues that, given managerial overconfidence, an optimal level of free
cashflow exists that eliminates both the Myers-Majluf and Jensen problem. Our first
model builds on Heaton’s (2002) analysis by adding asymmetric information between
managers and investors. Furthermore, in contrast to Heaton, we do not consider the
role of free cash flow. Instead, we concentrate on the effect of overconfidence on the
manager’s choice between debt and equity. In our asymmetric information model,
overconfidence is unambiguously bad, since it leads to excessive use of debt, hence
increasing the prospects of financial distress.
Our second model is similar in spirit to Hackbarth’s (2002) work, combining moral
hazard and overconfidence. In Hackbarth’s (2002) capital structure model, higher debt
levels, and hence managerial optimism and overconfidence, are beneficial for
shareholders. Hackbarth presents two versions of the model. In the first version, the
manager attempts to act in the interest of shareholders, His objective is to maximise
the perceived value of the firm (trading-off tax benefits versus bankruptcy costs of
debt). Since an overconfident manager perceives debt as more undervalued than
equity, he issues higher level of debt than a rational manager. In the second version of
Hackbarth’s model, the agency problem of free cashflow exists (as in Jensen 1986).
An overconfident manager chooses a higher debt level than a rational manager. This
serves to mitigate the free cashflow problem, hence aligning managers’ and
shareholders’ objectives. We contribute to Hackbarth’s model by examining positive
and negative effects of managerial overconfidence in the presence of moral hazard.
In contrast to our asymmetric information model, the relationship between
overconfidence and firm value is ambiguous in our moral hazard model. We
demonstrate that increasing overconfidence may be good for shareholders, since
managers are induced to exert higher effort levels. However, increasing
overconfidence may lead to an increase in expected financial distress associated with
higher debt financing. Hence, our model provides a contribution to the debate by
considering both positive (effort level) and negative (excessive debt) effects of
overconfidence. We thus suggest that there may be an optimal level of
overconfidence, trading off these two effects in order to maximise firm value.
The rest of the paper is organized as follows. In section II, we analyse our asymmetric
information/overconfidence model. In section III, we turn to our analysis of moral
hazard and overconfidence. In section IV, we discuss policy implications arising from
our models, and potential future research. Section V concludes.

5
II. A model of overconfidence and asymmetric information.

We consider an economy consisting of two firms and a capital market. Each firm is
run by a manager i ∈ {g , b} (where g represents a good, high ability manager, and b
represents a bad, low ability manager). All agents are risk-neutral, and the risk-free
rate is zero.
Each firm has an investment opportunity at date 0, requiring investment of I . The
managers have no free cashflow, and must approach the capital market to raise funds.
Two financing instruments are available to the firm, debt D or equity E . To simplify
the analysis, we assume that managers fund the project entirely with equity or debt.

At date 1, two possible states can occur. In the ‘high’ state H the project will realise
income of R. In the ‘low’ state L the project will realise zero income. The
probability of state H occurring is P, and the probability of state L occurring is
1 − P. For manager g , P = p, and for manager b, P = q. Since manager g is of
higher ability than manager b, p > q.

In the fully rational case, the manager and the market agree on the true good state
probabilities p and q. The behavioral factor of overconfidence is modelled as
follows. The good manager believes that his true good state probability is pˆ > p, and
the bad manager believes that his true good state probability is qˆ > q. Each manager,
therefore, believes that the market underestimates his good state probability.
Furthermore, each manager knows the other manager’s estimate. We consider two
interesting possibilities here. Either each manager believes that the market is correct
in terms of the other manager. Therefore, each manager knows that the other manager
is overconfident, but believes himself to be rational. On the other hand, each manager
could believe the market to be irrational in valuing both managers’ equity.

A. Financial contracts.

Manager i can raise the investment funds I by either issuing debt or equity at date 0.
Firstly, consider the case where the manager issues debt of value I at date 0, and loan
rate r. If the good state occurs at date 1, income R is realised. The debtholders
receive fixed payment I (1 + r ) , with the manager keeping the balance R − I (1 + r ). In
the bad state, zero income is achieved, and the manager faces financial distress costs
b. Therefore, under the debt contract, the manager’s expected payoff is

M i = PR − PI (1 + r ) − (1 − P )b. (1)

Note that the manager’s security issuance provides signals to the market of
managerial ability. Let P represent the market’s belief of the good state probability,
given the security issued. Further, assume a competitive capital market, investing at
zero NPV. Hence, P I (1 + r ) = I .

6
Next, consider the case where the manager issues equity. Let outside equityholders
hold a fraction α in the firm, and the manager hold the balance 1 − α in the firm.
Further, consider the ‘excess transfer’; that is, the amount that outside equity holders
contribute in excess of the required investment funds. Therefore, X = (1 − α )V0 − I ,
where V0 is the date 0 total market value of the firm, affected by the signalling
properties of the security issued. Therefore, under the equity contract, the manager’s
expected payoff is

M i = αPR + X . (2)

Note that, since we assume a competitive capital market, X = 0.

We solve the game using the concept of Pure Bayesian equilibria (PBE). Prior to
security issuance by manager i ∈ {g , b}, investors cannot identify managerial type,
and therefore assign equal probability to each manager being of each type. The
managers’ security issuance provides signals to the market. Having observed the
security issue by each firm, the investors update their beliefs as follows;

µ{i = g / Si = D, S j = E} = µ{ j = b / Si = D, S j = E} = 1, (3)
1
µ{i = g / Si = S j = D} = µ{ j = b / S i = S j = D} = , (4)
2
1
µ{i = g / Si = S j = E} = µ{ j = b / Si = S j = E} = , (5)
2

where µ (i / S i , S j ) represents the posterior probability of the manager being of type

i ∈ {g , b} given that the market observes security S i , S j ∈ {D, E}. Under PBE, the
managers’ security issuance must be optimal given these beliefs, and the equilibrium
must be consistent with these beliefs.
Belief (3) states that, if the managers separate, with the good manager issuing debt
and the bad manager issuing equity, managerial type is revealed to the market. Beliefs
(4) and (5) state that, if both managers pool by issuing the same security (either debt
or equity), investors cannot update their beliefs (they still assign equal probability to
each manager being of each type).

If the market observes that both managers have issued debt, from belief (4),
p+q
P= . Therefore, the loan rate satisfies
2

p+q 2I
I (1 + r ) = I ⇔ I (1 + r ) = . (6)
2 p+q

If the market observes that both managers have issued equity, from belief (4), and
X = 0,

7
 p+q
(1 − α ) R = I. (7)
2

If the market observes that manager i has issued debt, and manager j has issued
equity, investors can identify type. Therefore, the loan rate satisfies
I
pI (1 + r ) = I ⇔ I (1 + r ) = , while the outside equity stake satisfies (1 − α ) qR = I .
p

We analyse the effect of managerial overconfidence on equilibrium security issuance.

We model managerial overconfidence relating to the good state probability as follows.
The good manager believes that the good state probability is pˆ ≥ p, and the bad
manager believes that the good state probability is qˆ ≥ q. When managers are fully
rational (no overconfidence), pˆ = p, and qˆ = q.

Proposition 1 describes the effect of expected financial distress costs on the equilibria
of the security issuance game.

Proposition 1:

a) When the managers are fully rational (no overconfidence),

p−q
a) If I ≥ (1 − q)b > (1 − p )b, the equilibrium is {S g = S b = D}.
p+q
p−q
b) If (1 − q)b ≥ I > (1 − p )b, the equilibrium is {S g = D, S b = E}.
p+q
p−q
c) If (1 − q)b > (1 − p )b ≥ I , the equilibrium is {S g = S b = E}.
p+q

b) When the managers are irrational (managerial overconfidence),

qˆ ( p − q)
a) If I ≥ (1 − qˆ )b > (1 − pˆ )b, the equilibrium is {S g = S b = D}.
q( p + q )
qˆ ( p − q)
b) If (1 − qˆ )b ≥ I > (1 − pˆ )b, the equilibrium is {S g = D, S b = E}.
q( p + q )
qˆ ( p − q)
If (1 − qˆ )b > (1 − pˆ )b ≥ I , the equilibrium is {S g = S b = E}.
q( p + q )

Proof: See Appendix.

In contrast to standard security signalling models, our model derives separating and
pooling equilibria. The extent of debt issuance (that is, both managers issue debt, only
the good manager issues debt, or no manager issues debt) depends on each manager’s

8
expected financial distress costs, (1 − q)
ˆ b and (1 − p)
ˆ b , and the difference between
the good and bad manager’s ability, ( p − q ).

Furthermore, comparison of propositions 1a) and 1b) suggests that overconfidence

qˆ ( p − q) p−q
leads to a greater occurrence of debt issuance (since I > I ). We
q( p + q ) p+q
analyse the implications of this for total welfare and firm values in the next section.

The Effect of Managerial Overconfidence on Welfare.

In this section, we consider the effects of managerial overconfidence on total welfare.

In order to analyse the welfare effects of overconfidence, we consider the good and
bad manager’s respective payoffs, M g and M b , resulting from the various
combinations of security issue (these are given in the equations A1 –A8 in the
appendix). Note that the security-holders’ payoff (net of initial finance) is S = 2I .
We assume that the payoffs are additive. Therefore, we define total welfare, given
each manager’s security issuance Si , as W ( S i ) = M g + M b + S = M g + M b + 2 I .

We consider welfare from the point of view of a rational outside observer, who knows
that the true good state probabilities for the good and bad manager are p and q
(rather than p̂ and q̂ ). hence, we replace p̂ and q̂ with p and q in M g and M b ,
and substitute into W ( Si ) . Therefore, in the case where both managers issue debt,
total welfare is given by (A1) + (A2) + 2I ; that is;

W ( S g = S b = D ) = pR + qR − (1 − p )b − (1 − q )b. (8)

In the case where manager g issues debt, and manager b issues equity, total
welfare is given by (A3) + (A4) + 2I ; that is;

W ( S g = D, S b = E ) = pR + qR − (1 − p )b. (9)

In the case where both managers issue equity, total welfare is given by (A7) +
(A8) + 2I ; that is;

W ( S g = S b = E ) = pR + qR. (10)

We note that, due to the existence of financial distress costs under debt, welfare is
maximised when both managers issue equity. Second-best welfare is achieved
when manager g issues debt, and manager b issues equity. Welfare is minimised
when both managers issue debt.

Under moral hazard (as analysed shortly in our second model), debt can have a
positive role. For example, the bankruptcy threat can motivate managers to higher

9
effort levels. By focussing on the signalling role of debt, our current model
abstracts from such positive effects. The signalling effect of debt only has an
allocative role in terms of firm values. This is revealed by observing that pR + qR
appears in (10), (11) and (12), while comparison of (A1) – (A8) in the appendix
reveals different wealth allocations to the managers, depending on the security
issuance. Furthermore, increased use of debt by the managers has greater negative
effect on welfare through expected financial distress costs. In summary, in our
model, debt has an unambiguously negative effect on total welfare.
Of course, managers are not interested in total welfare. They are only interested in
their own payoffs. Our model reveals that asymmetric information problems
provide an incentive for managers to issue debt in order to signal ability, even
though this carries welfare-reducing expected financial distress costs.

We now turn to the focus of our analysis; the effect of managerial overconfidence.
Comparison of proposition 1a) and 1b) reveals that the issuance of debt to signal
ability (and the resulting reduction in welfare) occurs for a larger range of
expected financial distress costs when managers are overconfident. Comparison of
the two propositions provides the following result;

Corollary: (overconfidence results in greater debt issuance).

qˆ ( p − q) p−q
a) If I ≥ (1 − q)b > (1 − qˆ )b > (1 − p )b > (1 − pˆ )b > I , rational g
q( p + q ) p+q
and b managers both issue equity (because the expected financial distress costs
are too high), and welfare is maximised. However, overconfident g and b
managers both issue debt, and welfare is minimised.
qˆ ( p − q) p−q
b) If (1 − q)b > (1 − qˆ )b ≥ I > (1 − p )b > (1 − pˆ )b > I , the bad
q( p + q) p+q
manager issues equity, whether he is rational or overconfident. A rational good
manager issues equity, while an overconfident good manager issues debt.
qˆ ( p − q)
c)If (1 − q)b > (1 − qˆ )b > (1 − p )b > (1 − pˆ )b ≥ I , both managers issue
q( p + q )
equity, whether they are rational or overconfident.

The corollary reveals that overconfidence provides two reinforcing incentives for
debt issuance. Firstly, an overconfident manager overvalues his equity compared
qˆ ( p − q) p−q
to the market. This is reflected by I> I . Secondly, an
q( p + q ) p+q
overconfident manager undervalues his expected financial distress costs, reflected
by (1 − q )b > (1 − qˆ )b, and (1 − p )b > (1 − pˆ )b.

The corollary is demonstrated in the following diagram.

10
 Effect of Overconfidence on Welfare

350

300

250

200
Value

150

100

50

0
0

0
0
0
0
0
0
0
0
0
20
40
60
80
10
12
14
16
18
20
22
24
26
Distress costs (b).

Diagram 1: The Effect of Overconfidence on Welfare.

The top line represents welfare as a function of distress costs in the fully rational
case. The dashed line represents welfare as a function of distress costs in the
irrational, overconfident case.
qˆ ( p − q)
The top horizontal line represents the critical value I , which determines
q( p + q )
whether an irrational, overconfident manager issues debt or equity. The lower
p−q
horizontal line represents the critical value I , which determines whether a
p+q
rational manager issues debt or equity.

The ‘spray’ of lines radiating from the origin represent the managers’ expected
financial distress costs. The lowest line represents (1 − p)
ˆ b . The next lowest
represents (1 − p )b. The next line represents (1 − qˆ )b. Finally, the top line
represents (1 − q )b. Hence, an overconfident manager believes that his expected
financial distress costs are lower than they actually are.

Consider the welfare functions. At low levels of financial distress costs, both
managers issue debt. Hence, welfare is given by (8), and increasing financial
distress costs unambiguously reduces welfare. The first upward ‘step’ represents
the critical level of financial distress costs at which manager b switches from
issuing debt to equity. Since manager g continues to issue debt, welfare is now
given by (9), and increasing financial distress costs from this step to the second

11
 upward step reduces welfare. The second upward ‘step’ represents the critical
level of financial distress costs at which manager g also switches from issuing
debt to equity. Since both managers now issue equity, financial distress costs are
totally eliminated, and total welfare is given by (10). Therefore, the total welfare
function is horizontal after the second step upward.

As noted previously, managers are not interested in total welfare, but in the
signalling effects of debt on their own payoffs. Therefore, as a result of
asymmetric information, they have an incentive to issue welfare-reducing debt, in
order to signal ability. It is interesting to note that increasing financial distress
costs can actually increase welfare, by eliminating the managers’ incentives to
issue debt.

A key observation from the diagram is that the overconfidence leads to a more
widespread use of debt financing. Therefore, overconfidence results in larger
welfare losses than in the rational case.

It is interesting to compare our model with Heaton’s (2002) model. In both

analyses, the managers believe that the market undervalues their equity. However,
Heaton assumes symmetric information, and so the managers’ belief comes from
his overconfidence. He overvalues the equity, and the market values it correctly.
In our model, we consider both overconfidence and asymmetric information.
Therefore, the manager overvalues the equity, and the market undervalues it.

III. A model of overconfidence and moral hazard.

In the previous model, we considered the combined effects of asymmetric

information and managerial overconfidence on the equilibrium security issue.
Debt was unambiguously welfare-reducing, since it merely re-allocated firm value
between firms (due to its signalling role), but had negative welfare effects due to
expected financial distress costs. Further, we demonstrated that managerial
overconfidence resulted in increased use of debt. We did not consider moral
hazard problems.
We now consider the combined effects of moral hazard and managerial
overconfidence (without considering asymmetric information problems). In this
case, overconfidence may be value-increasing or value reducing.
Consider a firm which requires date 0 investment funds I for its one available
one-period project. Having received the funds and invested in the project, the
manager of the firm exerts effort e. He faces cost of effort C (e) = βe 2 . The
project either succeeds or fails at date 1, providing income of R or zero
respectively.
The manager’s effort level e affects the project’s success probability. That is, the
probability of success is P = (λ + γ )e ∈ (0,1] (and, of course, with complementary
probability, the project fails). Therefore, λ + γ represents the effect of managerial
effort on the success probability. The parameter γ represents managerial
overconfidence, as follows. The true value is γ = 0, so that the true success
probability is P = λe ∈ (0,1]. A rational manager understands this. For an

12
 overconfident manager, γ ∈ [0, γ max ] with larger γ representing a higher degree
of overconfidence. Note that we restrict the maximum possible amount of
overconfidence to γ max (the manager does not have unlimited overconfidence).
This facilitates our analysis of optimal overconfidence in proposition 2.
The manager can raise investment funds using either debt with exogenously given
face value D < R, or he can issue an exogenously given proportion of equity
(1 − α ), retaining a proportion α for himself1. As in our first model, investors
provide finance at zero net present value. The manager receives the investment
funds, invests I in the project, and retains the “excess transfer” X for himself.
Under the debt contract, if the project is successful, the manager receives income
R, and pays the face value D to the debtholders, retaining R − D for himself. If
the project fails, the manager is unable to pay the debtholders, and the firm faces
financial distress costs b. Therefore, the manager’s perceived expected income
is Pˆ ( R − D ) − (1 − Pˆ )b. Furthermore, the manager knows that the investors
evaluate the success probability2 as P. Under the debt contract, the debtholders
invest an amount PD. The manager’s perceived payoff consists of his perceived
income minus his cost of effort plus the excess transfer PD − I . Therefore, if the
manager issues debt, his perceived expected payoff3 is

M D = Pˆ ( R − D + b) − b − βe 2 + PD − I . (11)

Substituting for P̂, and solving ∂Mˆ D / ∂e = 0, we obtain the manager’s optimal
effort level under the debt contract;

( λ + γ )( R − D + b)
eD * = . (12)
2β

If he issues equity, his perceived expected payoff is

M E = αPˆ R − βe 2 + (1 − α ) PR − I . (13)

Substituting for P̂, and solving ∂Mˆ E / ∂e = 0, we obtain the manager’s optimal
effort level under the equity contract;

α (λ + γ ) R
eE * = . (14)
2β

1
In previous versions of the model, we imposed the condition that investors provide the exact required
amount of investment funds I , and then we solved for the equilibrium face value of debt and equity
proportions endogenously. This proved very laborious, and provided very unclear comparative results.
2
We emphasise that the investors are rational, and that their evaluation of the success probability, P,
is correct. However, following Heaton (2002), the overconfident manager believes himself to be
rational, and believes that the investors are irrational. Hence, he thinks that the investors are
undervaluing the success probability.
3
Throughout the analysis, we use ^ to signify the overconfident manager’s perceptions.

13
In order to facilitate comparison of the debt and equity contracts, we equate the
exogenously given face value of debt in the debt contract, and the manager’s
exogenously given equity stake in the equity contract, as follows;
R−D
R − D = αR <=> α = .
R

Therefore, the manager’s optimal effort level under equity becomes

( λ + γ )( R − D )
eE * = . (15)
2β

Hence;

Lemma: (The effect of overconfidence and security choice on managerial effort).

a) ∂eD * / ∂γ > 0, ∂eE * / ∂γ > 0; the manager’s effort level is increasing in his
overconfidence level.
b) eD * > eE * ∀b > 0, and eD * = eE * if b = 0. Debt forces a higher effort level
due to the threat of expected financial distress.

In order to derive the manager’s choice of security, we substitute the optimal

effort levels back into the payoffs, to obtain the manager’s perceived indirect
payoffs as follows;

( λ + γ ) 2 ( R − D + b) 2 λ ( λ + γ )( R − D + b) D
Mˆ D = + − I −b (16)
4β 2β
(λ + γ ) 2 ( R − D ) 2 λ ( λ + γ )( R − D ) D
ME =
ˆ + − I. (17)
4β 2β

In (16), the first term represents the manager’s share of the project income in
excess of the face value of debt minus the cost of effort. In (17), the first term
represents the manager’s equity stake minus the cost of effort. In both (16) and
(17), the second and third terms represent the excess transfer from the investors.
This captures the idea that, since investors provide finance at zero NPV, the
manager gains all of the positive NPV. However, this is complicated by
managerial overconfidence, such that the manager believes that the investors
underestimate the probability of success.
Define the overconfident manager’s gain from issuing debt (compared to equity)
as

( λ + γ ) 2 ( 2b( R − D ) + b 2 ) λ (λ + γ )bD
∆Mˆ D = Mˆ D − Mˆ E = + − b. (18)
4β 2β
Therefore, the manager chooses debt iff ∆Mˆ D ≥ 0, otherwise he chooses equity.

The true expected value of the firm at date 0 is

14
 λ ( λ + γ )( R − D + b)( R + b)
VD = PD ( R + b) − b = − b. (19)
2β

λ ( λ + γ )( R − D ) R
VE = PE R = . (20)
2β

In order to analyse the effect of managerial overconfidence on security choice and

firm value, we consider, as a benchmark, the effect on firm value when the
manager is rational (γ = 0). In this case,

λ2 (2b( R − D ) + b 2 ) λ2 bD
∆M D (γ = 0) =
ˆ + − b. (21)
4β 2β
In order to focus the analysis, we assume that ∆Mˆ D (γ = 0) < 0. Therefore, a
rational manager will choose equity. The intuition is that he is aware of the true
effect of his effort on the success probability, and this is low in relation to the
expected financial distress costs of debt. Therefore, when γ = 0, the value of the
firm is

λ2 ( R − D ) R
VE (γ = 0) = . (22)
2β

Examination of (18) reveals that ∂∆Mˆ D / ∂γ > 0. Therefore, there will be a critical
overconfidence parameter γ C at which ∆Mˆ D (γ = γ C ) = 0. Hence, if γ ∈ [0, γ C ],
the manager will issue equity, while if γ > γ C , he will issue debt.

In order to complete the analysis of the effect of overconfidence on firm value, we

need to consider the effect of the manager switching from equity to debt at γ C .
We compare (19) with (22). Define

( λ2 + λγ )( 2bR − Db + b 2 ) + λγ ( R( R − D ))
VD (γ ≥ γ C ) − VE (γ = 0) = − b. (25)
2β

This represents the difference in firm value between the benchmark case (where
the manager is rational and chooses equity) and the case where the manager is so
overconfident that he switches to debt. If VD (γ = γ C ) − VE (γ = 0) ≥ 0, firm value
at the critical security-switching point (where the overconfident manager switches
to debt) is at least as high as the firm value when the fully rational manager issues
equity. If VD (γ ≥ γ C ) − VE (γ = 0) < 0, firm value at the critical switching point
(where the overconfident manager switches to debt) is lower than when the
manager is fully rational and issues equity. In this case, we define a second critical
value γ C ' at which VD (γ = γ C ' ) − VE (γ = 0) = 0. That is, at this second critical
value of overconfidence, firm value under debt becomes higher than when the
manager is fully rational and issues equity.

15
 This provides our main results.

Proposition 2.

For a given choice of security (debt or equity), firm value is increasing in

managerial overconfidence (∂VD / ∂γ > 0 and ∂VE / ∂γ > 0).
a) If VD (γ = γ C ) − VE (γ = 0) ≥ 0, firm value is unambiguously higher for any
level of managerial overconfidence, compared to the fully rational case.
Therefore, the optimal level of overconfidence is γ * = γ max .
b) If VD (γ = γ C ) − VE (γ = 0) < 0; there are two possible cases. In case 1;
i.)For low levels of overconfidence, γ ∈ [0, γ C ], the manager issues equity,
and firm value is increasing in overconfidence.
ii) For medium levels of overconfidence, γ ∈ [γ C , γ C ' ], the manager
issues debt, and firm value is lower than when then manager is
rational (for the entire interval of overconfidence γ ∈ [γ C , γ C ' ], ),
but is still increasing in overconfidence.
iii) For high levels of overconfidence, γ ∈ [γ C ' , γ max ], the manager
issues debt, firm value is higher than when the manager is
rational, and is increasing in overconfidence. The optimal level of
overconfidence is γ * = γ max .

In case 2:
i.) For low levels of overconfidence, γ ∈ [0, γ C ], the
manager issues equity, and firm value is increasing in
overconfidence.
ii.) For high levels of overconfidence, γ ∈ [γ C , γ max ], the
manager issues debt, and, although firm value is
increasing in overconfidence, it remains lower than when
the manager is fully rational for the entire interval of
overconfidence. The optimal level of overconfidence is
γ * = γ C − δ (with δ close to zero). This is the highest
possible overconfidence level at which the manager still
issues equity.

This proposition is demonstrated in the following diagrams4. In each diagram, the line
crossing the x-axis represents ∆M D . When this line is below the x-axis, the manager

4
Note that we have considered a binary decision over financing (the manager can either issue debt
or equity), and two possible project outcomes (good or bad). These features have made the model
tractable, and provided a sharp trade-off between the positive effects of overconfidence on
managerial effort and the negative effect of financial distress costs when the manager switches to
debt. In a future version of the model, we will consider a continuum of possible debt levels and
project states to sharpen the results.

16
issues equity. When the line is above, he issues debt. The other line represents firm
value. Diagram 2 represents proposition 2a). That is, firm value is unambiguously
increasing in managerial overconfidence. The positive effect of overconfidence on
managerial effort exceeds the negative effect of expected financial distress costs when
overconfidence induces the manager to switch from equity to debt. The optimal level
of overconfidence is γ * = γ max .
Diagram 3 represents proposition 2b). For medium levels of overconfidence, the
manager switches from equity to debt, and firm value is lower than when the manager
is fully rational. Medium levels of overconfidence are undesirable, because the
manager switches to debt, but does not exert sufficient effort to offset the negative
expected financial distress costs. For high levels of overconfidence, the manager
issues debt, and firm value is higher than when the manager is fully rational. The
optimal level of overconfidence is γ * = γ max .

Diagram 4 represents proposition 2c). An excessive level of overconfidence is

undesirable, because, under the debt contract, the manager does not exert sufficient
effort for any level of overconfidence to exceed the expected financial distress costs.
Now, the optimal level of overconfidence is the maximum level such that the manager
still issues equity γ * = γ C − δ , with δ close to zero.

Effect of Overconfidence on Firm Value

1200
1000
800
600
Value

400
200
0
-200 0 0.1 0.2 0.3 0.4 0.5
-400
-600
Overconfidence

Diagram 2: Firm value is unambiguously increasing in overconfidence. Firm value is

maximised when γ * = γ max .

17
 Effect of Overconfidence on Firm Value

2500
2000
1500
Value 1000
500
0
-500 1 2 3 4 5 6 7 8 9 10

-1000
-1500
-2000
Overconfidence

Diagram 3: Firm value is minimised for medium overconfidence (since the

negative expected financial distress costs exceed the positive effect of
overconfidence on managerial effort. Firm value is maximised when γ * = γ max .

Effect of Overconfidence on Firm Value

2000

1500
1000

500
Value

0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
-500

-1000
-1500

-2000
Overconfidence

Diagram 4: Firm value is maximised γ * = γ C − δ , with δ close to zero. For high

levels of overconfidence, the manager switches to debt, and the negative expected
financial distress costs exceed the positive effect of overconfidence on managerial
effort.

18
 The diagrams demonstrate the conflict between the overconfident manager’s
inflated perception of his payoff (driven by his overconfidence in his ability to
generate a successful project outcome), and the true value of his payoff and firm
value. Particularly, in diagram 4, a high level of overconfidence induces the
manager to believe that issuing debt is value-increasing, when it is in fact value-
reducing.

IV. Discussion.

Much of the existing research in behavioral finance focuses on the psychological

biases affecting investors in the financial markets. Thaler (1999) calls for an
increased level of research in the area of behavioral corporate finance (that is, an
increased understanding of the effects of managerial psychological biases). Since
then, major steps have been taken in modelling the effect of one particular bias,
managerial overconfidence, on investment and financing decisions.
In this paper, we have built on two specific capital structure/managerial
overconfidence models belonging to Heaton (2002) and Hackbarth (2002). In our
first case, we considered the signalling role of debt in an asymmetric information
model, without moral hazard problems. Overconfidence led managers to
overestimate the probability of good states, and to underestimate the probability of
bankruptcy. This resulted in excessive use of welfare-reducing debt.
In our second case, we considered the commitment role of debt in a moral hazard
model, without asymmetric information problems. In this case, the effect of
overconfidence on firm value is ambiguous. Overconfidence has both positive and
negative effects on shareholder wealth. That is, overconfidence induces higher
managerial effort, but may also result in excessive value-reducing debt levels (due
to an increase in expected financial distress).
This ambiguity provides an interesting policy insight. Overconfidence may
provide a rationale for the empirical observation that many companies take on
excessive debt at some time (Shefrin 1999). For example, in his case study of BT,
Fairchild (2003b) argues that the company took debt in excess of the optimal
level, and were slow to reduce debt. Was this a result of managerial
overconfidence?
Zacharakis and Shepherd (2001) argue that overconfidence may result in venture
capitalists providing insufficient research effort into new proposals, hence making
errors of judgment in deciding on which ventures to fund. They argue that venture
capitalists should be educated out of overconfidence. However, we have
demonstrated that overconfidence is not necessarily undesirable.
In contrast to the research into behavioral financial markets, the research into
behavioral corporate finance is still relatively young. The rigorous theoretical
developments have focussed on managerial overconfidence. However, we believe
that the existing models of investor irrationality (eg Barberis et al 1998 and Daniel
et al 1998) could be developed and applied to managerial irrationality. Indeed, an
examination of Statman and Caldwell’s (1987) survey of the biases facing
managers in investment appraisal decisions (eg framing combined with prospect
theory, regret aversion, loss aversion)5 reveals that managers exhibit much of the
same biases that face investors. Hence, it should be relatively straight-forward to

5
For a review of Statman and Caldwell (1987), see Fairchild (2005).

19
 extend models of investor irrationality regarding share trading and pricing to
models of managerial irrationality regarding investment appraisal and capital
structure decisions.
Furthermore, it is possible that the managerial biases in investment appraisal
decisions, as identified by Statman and Caldwell, could be extended to financing
decisions. For example, Staman and Caldwell discuss a manager’s refusal to
abandon a loss-making project, due to various biases, such as framing, loss
aversion, and regret aversion. We could conceivably apply this to capital structure,
where a manager might experience a refusal to abandon a high value-reducing
debt level, especially if he had been involved in the initial decision to take on high
debt. Furthermore, Hirschleifer (1993) discusses some behavioral biases that
could be applied to debt decisions, such as reputation effects and short-termism.
Capital structure models that combine several managerial biases will provide
much richer policy implications than examining, say, overconfidence in isolation.
What will be the effect of combining biases on a manager’s value-increasing or
value-reducing activities. Indeed, Besharov (2002) develops a model that
combines 3 biases (overconfidence, regret aversion and hyperbolic discounting6).
Overconfidence and regret aversion result in higher effort levels, while hyperbolic
discounting results in lower effort levels. Therefore, these biases offset each other.
It would be interesting to apply Besharov’s (2002) model to corporate finance
decision-making.

V. Conclusion.

We have developed a financial structure model in order to examine the combined

effects of managerial overconfidence, asymmetric information and agency
problems. Our main results are as follows; a) in the asymmetric information
model, overconfidence is unambiguously bad. It induces excessive use of welfare-
reducing debt, b) in the moral hazard model, the effect of overconfidence is
ambiguous. It has a positive effect by inducing higher managerial effort. However,
it may lead excessive use of debt and higher expected bankruptcy costs. Overall,
we contribute to the debate on managerial overconfidence by demonstrating that it
is not necessarily bad for shareholders.
Our model can be used to explain the large numbers of companies taking on high
debt levels, and refusing to reduce debt when it is obvious that they should.
Future research should develop further the analysis of the relationship between
overconfidence, capital structure and firm value. Furthermore, we should analyse
the effects of other managerial biases in financing decisions. Since there are
potentially an infinite number of such biases (for instance, framing, loss aversion,
regret aversion, hyperbolic discounting, in addition to emotional biases), this
should present an interesting and challenging agenda for behavioral corporate
finance research.

6
Proper NPV analysis employs exponential discounting. Under hyperbolic discounting, the manager
discounts future cashflows excessively. Hyperbolic discounting reflects both a short-termist bias, and
time-inconsistent decision-making.

20
 Appendix.

Proof of proposition 1:

Given the managers’ security issue, and the expectations of the market, we derive the
following payoffs.

If both managers issue debt, the payoffs are;

M g = pˆ R − pˆ I (1 + r ) − (1 − pˆ )b,

M b = qˆ R − qˆI (1 + r ) − (1 − qˆ )b.

The market knows the true good state probabilities, and so sets the loan rate such that
p+q
I (1 + r ) = I . Therefore, the payoffs become
2

2 pˆ I
M g = pˆ R − − (1 − pˆ )b, (A1)
p+q

2qˆ I
M b = qˆ R − − (1 − qˆ )b. (A2)
p+q

If the good manager issues debt, and the bad manger issues equity,
M g = pˆ R − pˆ I (1 + r ) − (1 − pˆ )b, combined with pI (1 + r ) = I , produces

pˆ
M g = pˆ R − I − (1 − pˆ )b, (A3)
p

while M b = αqˆR + X , combined with X = (1 − α ) qR − I = 0, produces

qˆ
M b = qˆR − I. (A4)
q

If the bad manager issues debt, and the good manager issues equity, M g = αpˆ R + X ,
combined with X = (1 − α ) qR − I = 0, produces
pˆ
M g = pˆ R − I , (A5)
q

While M b = qˆ R − qˆI (1 + r ) − (1 − qˆ )b, combined with pI (1 + r ) = I , produces

qˆ
M b = qˆR − I − (1 − qˆ )b. (A6)
p

21
These strategies are inconsistent with beliefs, and cannot constitute an equilibrium.

Finally, if both managers issue equity, M g = αpˆ R + X , and M b = αqˆR + X ,

p+q
combined with X = (1 − α ) R − I = 0, produces
2

2 pˆ
M g = pˆ R − I, (A7)
p+q

2qˆ
M b = qˆ R − I. (A8)
p+q

We solve for the equilibria of the security signalling game by considering each
manager’s best responses given the other manager’s security issuance.
Firstly, consider manager b' s best responses, given manager g' s security issuance. If
manager g issues debt, manager b' s best response is to issue debt if (2) ≥ (4); that
is, if

qˆ ( p − q)
I ≥ (1 − qˆ )b. (c1).
q( p + q )

If manager g issues equity, manager b' s best response is to issue debt if (6) ≥ (8);
that is, if

qˆ ( p − q)
I ≥ (1 − qˆ )b. (c2).
p( p + q)

Next, consider manager g' s best responses, given manager b' s security issuance. If
manager b issues debt, manager g' s best response is to issue debt if (1) ≥ (5); that
is, if

pˆ ( p − q)
I ≥ (1 − pˆ )b. (c3).
q( p + q )

Finally, If manager b issues equity, manager g' s best response is to issue debt if (3)
≥ (7); that is, if

pˆ ( p − q)
I ≥ (1 − pˆ )b. (c4).
p( p + q)

22
To simplify the analysis, we assume that manager g and manager b are equally
pˆ qˆ
overconfident; that is = . Therefore, the left hand sides of conditions c1- c4 can
p q
pˆ ( p − q) pˆ ( p − q) qˆ ( p − q) qˆ ( p − q)
be ranked in the following order; I> I= I> I.
q( p + q ) p( p + q) q( p + q ) p( p + q)
Furthermore, since pˆ > qˆ , (1 − q)
ˆ b > (1 − pˆ )b.

qˆ ( p − q)
a) If I ≥ (1 − qˆ )b > (1 − pˆ )b, conditions c3 and c4 hold, so that the good
q( p + q )
manager’s dominant strategy is to issue debt. Furthermore, c1 holds, so that the bad
manager’s best response to debt issuance by the good manager is to issue debt.
Therefore, the equilibrium is {S g = S b = D}.
qˆ ( p − q)
b) If (1 − qˆ )b ≥ I > (1 − pˆ )b, c1 and c2 are violated, so that the bad
q( p + q )
manager’s dominant strategy is to issue equity. Furthermore, c4 holds, so that the
good manager’s best response to equity issuance by the bad manager is to issue debt.
Therefore, the equilibrium is {S g = D, S b = E}.
qˆ ( p − q)
c)If (1 − qˆ )b > (1 − pˆ )b ≥ I , c1 and c2 are violated, so that the bad
q( p + q )
manager’s dominant strategy is to issue equity. Furthermore, c4 is violated, so
that the good manager’s best response to equity issuance by the bad manager is to
issue equity. Therefore, the equilibrium is {S g = S b = E}.

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