14 Pages Posted: 12 Apr 1998
Date Written: September 1997
Considerable psychological evidence supports the existence of excessive optimism in the general population. I apply these findings to analyze some basic issues in corporate finance under the assumption that managers are excessively optimistic about the firm's prospects. A managerial optimism theory delivers empirical predictions that are highly consistent with the data, including the basic pecking order capital structure predictions that otherwise require informational asymmetries. Managerial optimism is most promising, however, as an alternative foundation for agency cost theories of corporate finance. The managerial optimism assumption aligns agency conflicts between managers and outside security holders with a well-established cognitive bias, instead of the less plausible and empirically unsupported assumption that managers knowingly destroy corporate wealth because they receive utility from empire-building. Among other things, this provides a much firmer foundation for free cash flow theories of debt.
JEL Classification: G30, G31, G32
Suggested Citation: Suggested Citation