Overconfidence and Early-life Experiences: The Impact of Managerial Traits on Corporate Financial Policies

TL;DR: This paper found that managers who believe that their firm is undervalued view external financing as overpriced, especially equity financing, and use less external finance and, conditional on accessing external capital, issue less equity than their peers.

Abstract: We show that measurable managerial characteristics have significant explanatory power for corporate financing decisions. First, managers who believe that their firm is undervalued view external financing as overpriced, especially equity financing. Such overconfident managers use less external finance and, conditional on accessing external capital, issue less equity than their peers. Second, CEOs who grew up during the Great Depression are averse to debt and lean excessively on internal finance. Third, CEOs with military experience pursue more aggressive policies, including heightened leverage. Complementary measures of CEO traits based on press portrayals confirm the results.

Summary

II. Data

• The authors primary sample is the data on CEOs' personal investments from Hall and Liebman (1998) and Yermack (1995) .
• 14 For each firm, kink is defined as the ratio of the hypothetical level of interest at which the expected marginal tax-shield benefits of debt start to fall to the actual amount of interest paid .

III. Measuring Overconfidence and Formative Experiences

• The measure Holder 67 is binary and is set equal to one once a CEO fails to exercise options with five years remaining duration despite a stock price increase of at least 67% since the grant date.
• They hold significantly less company stock, but more options than other CEOs.
• The directions of the effects are consistent with military experience as a proxy for aggressive beliefs and early-life experience during the Great Depression as a proxy for conservatism.
• Mirroring their analysis of overconfidence, the authors use CEOs' portrayal in the business press and the press data described in Section II.

A. Debt vs. Equity

• Next, the authors test the capital structure predictions of differences in CEO traits.
• In Column 3, the authors add the standard firm controls from the capital structure literature -the natural logarithm of sales, profitability, tangibility, and Q -to capture the effects of known cross-sectional determinants of changes in leverage (Rajan and Zingales (1995) ).
• Overall, CEOs that the authors classify as overconfident are less likely to issue equity conditional on accessing public securities markets, controlling for standard determinants of issuance decisions.
• 20 In Column 2, the authors add Longholder, its interaction with the financing deficit, firm fixed effects, and the interactions of firm fixed effects with the financing deficit.
• The authors find no significant difference between the Pre-and Post-Longholder portions of the Longholder estimate and very little effect of Holder 67, perhaps due to reduced sample size.

B. Internal vs. External Finance

• Overconfidence predicts not only a preference for debt over equity, but also for internal over external finance.
• In other words, even if overconfident CEOs choose more debt relative to equity than rational CEOs, the level of debt chosen may still be conservative relative to available tax benefits.
• The authors find nearly identical point estimates on both Depression Baby and Longholder, though the Longholder coefficient becomes marginally insignificant.
• The authors tabulate the distribution of net equity issues among Longholder CEOs and among Depression Baby CEOs separately for four different levels of kink: (i) kink ≤1, (ii) 1< kink ≤3, (iii) 3< kink ≤7, and (iv) kink >7.
• The authors find that higher levels of kink are associated with less equity issuance.

C. Leverage

• Recent research argues that there are large unexplained time-invariant effects in leverage (Lemmon, Roberts, and Zender (2008) ).
• Among the controls, only tangibility loses explanatory power when estimated using within-firm variation.
• In Column 7, the authors add their standard set of firm-level controls -profitability, tangibility, firm size, Q, and the financing deficit -and the relevant CEO-level controls -age and tenure.
• In Column 8, the authors refine their measure of military experience by separating World War II veterans, who are more likely to have had combat exposure, from other military CEOs.
• The authors also find similar results using an alternative methodology inspired by Baker and Wurgler (2002) , whereby they measure the relation between the change in leverage and the number of overconfident sample CEO-years (or, alternatively, "external finance weighted" overconfidence).

V. Alternative Interpretations

• The authors consider several alternative interpretations of their main measure of overconfidence, late option exercise.
• Personal taxes, board pressure, and procrastination are potential explanations for late option exercise, but have no plausible effect on CEOs' portrayal in the business press.

VI. Robustness: Extension to 2007

• As a final step, the authors extend their analysis beyond the 1980 to 1994 Hall-Liebman data.
• The fraction of World War II veterans declines similarly.
• ( 4) We replicate the overconfidence classification of Longholder_Thomson, but include all Execucomp CEOs who do not qualify as overconfident in the comparison group (Longholder_Thomson_Fill).the authors.the authors.
• In all cases, the authors find positive and significant correlations.
• The measure Longholder_Thomson (_Fill) should exactly match Longholder_Exec in CEOyears for which both are defined; however, the authors find a correlation of only 0.44 (0.48).

VII. Conclusion

• The authors provide evidence that managers' beliefs and early-life experiences significantly affect financial policies, above and beyond traditional market-, industry-, and firm-level determinants of capital structure.
• For a restricted range of parameters, an overconfident CEO may perceive debt to be more costly than equity.
• Items are coded as 0 when missing or combined with other items.

Figures

Table III

Table VII

Table V

Table I Empirical Predictions

Figure 1. Model Predictions (Stylized Example). The hypothetical example illustrates how overconfident CEOs may deviate from a hypothetical rational benchmark in their average financing of investment projects holding constant investment opportunities and financing needs. The example assumes a (hypothetical) rational benchmark of 33% cash, 33% debt, and 33% equity financing. Overconfident CEOs choose a lower absolute amount of debt financing (22% < 33%), but more debt financing relative to total new capital (22%/[22%+11%] > 33%/[33%+33%] ↔ 2/3 > 1/2) due to even lower absolute amounts of equity financing (11% < 33%).

Table II

Table VI

Table II

Table VIII

Table IV

Frequently asked questions

Q1. What are the contributions in "Overconfidence and early-life experiences: the effect of managerial traits on corporate financial policies" ?

The authors show that measurable managerial characteristics have significant explanatory power for corporate financing decisions. Earlier versions of this paper were titled “ Corporate Financial Policies with Overconfident Managers ” and “ Managerial Beliefs and Corporate Financial Policies. ” the authors are indebted to Brian Hall, David Yermack, and John Graham for providing us with the data. In this paper, the authors study the role of managerial traits in explaining the remaining variation. The authors consider both capital structure-relevant beliefs ( overconfidence ) and formative early-life experiences ( Great Depression, military service ). First, the authors consider managers who overestimate their firms ' future cash flows and hence believe that their firms are undervalued by the market. The authors show that such overconfident managers view external financing to be unduly costly and prefer to use cash or riskless debt.