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 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.

Keywords: Behavioral Corporate Finance, Managerial overconfidence, capital structure, asymmetric information, moral hazard.

JEL Classification: G32