Corporate Financial Policies With Overconfident Managers∗

There is wide debate over the causes and ultimate importance of the pecking order and debt conservatism to firm financing decisions. We argue that these empirical patterns are not driven solely by firmand market level variation, but are also linked to individual managerial characteristics. We relate the reluctance of (some) managers to access external capital markets, and particularly equity markets, to managerial overconfidence. Overconfident managers believe that their company is undervalued. They view external financing, and especially equity financing, as overpriced. We test the overconfidence hypothesis, classifying CEOs as overconfident if they persistently fail to reduce their personal exposure to company-specific risk. Alternatively, we classify CEOs based on their characterization in the business press. We find that, conditional on accessing public markets, overconfident CEOs are significantly less likely than other CEOs to issue equity. They raise roughly 30 cents more debt to cover an additional dollar of external financing deficit than their peers. Moreover, the frequency with which they access any external finance (debt or equity) is significantly lower than among other CEOs. Thus, the overconfidence explanation accounts for cross-sectional variation in corporate financial policies despite identical firm characteristics. ∗We are indebted to Brian Hall, David Yermack and John Graham for providing us with the data. We thank Malcolm Baker, Michael Faulkender, Dirk Hackbarth, Ilya Strebulaev, Jeffrey Wurgler and seminar participants in Stanford and at the ERIM RSM Rotterdam conference, the Olin Corporate Governance Conference, the FEA conference for helpful comments.