Managerial Optimism and Corporate Finance

Two dominant features emerge from a simple model of corporate finance with excessively managers and efficient capital markets. First, 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, 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 establish an underinvestmentoverinvestment tradeoff related to free cash flow without invoking asymmetric information or rational agency costs. In this paper, I explore the implications of a single specification of managerial irrationality in a simple model of corporate finance. Specifically, I focus on managerial optimism and its relation to the benefits and costs of free cash flow. Managers are optimistic when they systematically overestimate the probability of good firm performance and underestimate the probability of bad firm performance. This assumption finds support in a large psychological literature demonstrating that people are, in general, too optimistic. That literature presents two pervasive findings (e.g., Weinstein, 1980) that make optimism an interesting subject of study for corporate finance researchers. First, people are more about outcomes that they believe they can control. Consistent with this first experimental finding, survey evidence indicates that managers underplay inherent uncertainty, believing that they have large amounts of control over the firm's performance (see March and Shapira, 1987). Second, people are more about outcomes to which they are highly committed. Consistent with the second experimental finding, managers generally appear committed to the firm's success (somehow defined), probably because their wealth, professional reputation, and employability partially depend on it (e.g., Gilson, 1989). The approach taken here departs from the standard assumption of managerial rationality in corporate finance. Behavioral approaches are now common in asset pricing, of course, but little work in corporate finance has dropped the assumption that managers are fully rational.' This is somewhat surprising considering that the common objections to behavioral economics have less vitality in corporate finance than in asset pricing. The objection (rational agents will exploit irrational agents) is weaker, because there are larger arbitrage bounds protecting managerial irrationality than protecting security market mispricing. The most obvious of managerial irrationality-the corporate takeover-incurs high transactions costs, and the