Managerial Optimism: New Observations on the Unifying Theory

Abstract

Managerial optimism is behavioral finance's greatest achievement. It explains two prominent features of corporate financial behavior - over-investment and pecking order capital structure preferences - that otherwise require two different theories with mutually incompatible assumptions about managerial loyalties to shareholder-value maximization. After reviewing the development of managerial optimism as a unifying theory, I use a simple change-of-measure to transform risk-averse optimism to risk-neutral probabilities that can be pessimistic or optimistic depending on wealth changes. This unexplored feature has implications for, among other things, pay for performance when managers are excessively optimistic.

Keywords: behavioral corporate finance, managerial optimism, agency cost theory, asymmetric information theory, pay for performance