Managerial Optimism and Corporate Finance

Abstract

Two dominant features emerge from a simple model of corporate finance with excessively optimistic managers and efficient capital markets. First, optimistic managers believe that capital markets undervalue their firm's risky securities, and may decline positive net present value projects that must be financed externally. Second, optimistic managers overvalue their own corporate projects, and may wish to invest in negative net present value projects even when they are loyal to shareholders. These results imply an underinvestment-overinvestment tradeoff related to free cash flow, without invoking asymmetric information or rational agency costs.

Keywords: Behavioral Finance, Corporate Finance, Agency Costs, Asymmetric Information, Underinvestment, Overinvestment, Free Cash Flow

JEL Classification: G30, G31, G32, G34