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

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. University of California Berkeley and NBER, University of California at Los Angeles, and no affiliation. Earlier versions of this paper were titled “Corporate Financial Policies with Overconfident Managers” and “Managerial Beliefs and Corporate Financial Policies.” We are indebted to Brian Hall, David Yermack, and John Graham for providing us with the data. We thank Malcolm Baker, Rudi Fahlenbrach, Michael Faulkender, Murray Frank, Dirk Hackbarth, Dirk Jenter, Jeremy Stein, Ilya Strebulaev, Avanidhar Subrahmanyam, Jeffrey Wurgler, and seminar participants at Berkeley, Calgary, Columbia, Helsinki School of Economics, Insead, MIT, Rotterdam, Stanford, UCLA, USC, Wharton, Zurich, and at the AEA, AFA, FEA, Frontiers in Finance (Banff), IZA Behavioral Economics of Organizations, and Olin Corporate Governance conferences for helpful comments. Nishanth Rajan provided excellent research assistance. Ulrike Malmendier would like to thank the Alfred P. Sloan Foundation and the Coleman Fung Risk Management Research Center for financial support. 1 What are the primary determinants of firms' financing decisions? Traditional theories emphasize firm-, industry-, and market-level explanations, such as the trade-off between the tax deductibility of interest payments and bankruptcy costs, or asymmetric information between firms and the capital market (Miller (1977), Myers (1984), Myers and Majluf (1984)). These theories explain a significant portion of the observed variation in capital structure. Yet, recent research identifies firm-specific stickiness in capital structure that is not a clear prediction of the traditional theories (Lemmon, Roberts, and Zender (2008)). Moreover, while modern dynamic theories of optimal capital structure allow room for firms with similar fundamentals to operate away from a common target, the factors that predict these differences are less clear. In this paper, we study the role of managerial traits in explaining the remaining variation. We consider both capital structure-relevant beliefs (overconfidence) and formative early-life experiences (Great Depression, military service). In contrast to prior literature on managerial fixed effects (Weisbach (1995), Chevalier and Ellison (1999), Bertrand and Schoar (2003), Frank and Goyal (2007)), we identify specific managerial characteristics, derive their implications for financial decisions, and measure their effects empirically. To avoid confounds with firm characteristics (e.g., due to the endogenous matching of CEOs to firms (Graham, Harvey, and Puri (2009))) we use a fixed effects estimation strategy where possible to compare CEOs with different traits operating the same firm. First, we consider managers who overestimate their firms' future cash flows and hence believe that their firms are undervalued by the market. We show that such overconfident managers view external financing to be unduly costly and prefer to use cash or riskless debt. Conditional on having to raise risky external capital, they prefer debt to equity, since equity prices are more sensitive to differences in opinions about future cash flows. Unconditionally, however, their reluctance to access external financing may result in low levels of risky debt relative to available interest tax deductions (and even lower levels of equity).