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Managerial Optimism and Corporate Finance

14 Pages Posted: 12 Apr 1998  

J.B. Heaton

Bartlit Beck Herman Palenchar & Scott LLP

Multiple version iconThere are 2 versions of this paper

Date Written: September 1997

Abstract

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

Heaton, J.B., Managerial Optimism and Corporate Finance (September 1997). Available at SSRN: https://ssrn.com/abstract=71411 or http://dx.doi.org/10.2139/ssrn.71411

J.B. Heaton (Contact Author)

Bartlit Beck Herman Palenchar & Scott LLP ( email )

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