Managerial Overoptimism and the Choice Between Debt and Equity Financing

Michael Gombola and Dalia Marciukaityte

This paper compares long-run stock performance following debt financing and equity financing for a sample of rapidly growing firms. If managers are subject to overly optimistic predictions for their asset acquisitions, they are more likely to finance asset growth by debt rather than by equity. The managerial overoptimism hypothe- sis predicts worse long-term performance for debt-financed asset acquisitions than equity-financed asset acquisitions. If, on the other hand, managers take advantage of “windows of opportunity” for issuing equity, we expect worse performance following equity issuance than following debt issuance. Consistent with the managerial overop- timism hypothesis, we find that debt financing is followed by significantly worse stock performance than equity financing. Managerial overoptimism seems to be a signifi- cant factor affecting the choice between debt and equity financing and post-financing stock performance.

keywords: Overoptimism, Overconfidence, Debt financing, Equity financing, Long- run stock performance

Introduction

Evidence of poor stock and operating performance following equity issues has led to the hypothesis that managers take advantage of periods of high stock prices and investor overoptimism in order to sell over- priced equity. This “windows of opportunity” hy- pothesis suggests that managers time equity issues when their firm’s shares are overpriced (Ritter [1991]). This hypothesis, however, cannot be used to explain poor stock performance following debt issues doc- umented by Spiess and Affleck-Graves [1999] and Datta, Iskandar-Datta and Raman [2000]. Underper- formance following debt financing indicates a need for an alternative hypothesis that can explain these find- ings.

We suggest that managerial overoptimism is a fac- tor that can explain poor long-term stock performance following stock and, especially, bond issuance. Recent studies show that managerial overoptimism affects cor- porate decisions (e.g., Heaton [2002], Gervais, Heaton and Odean [2003], Malmendier and Tate [2003 and 2005]). As managers are more affected by the per- formance of their firm than are well-diversified share- holders, moderate managerial overoptimism can help

Michael Gombola Department Head and Professor of Finance, LeBow College of Business, Drexel University, Mail Stop 11-106, 3141 Chestnut Street, Philadelphia, PA 19104. Tel: 215-895-1743; Email: [email protected]

Dalia Marciukaityte Associate Professor of Finance, College of Business, Louisa Tech University, P.O. Box 10318, Room 205A, Ruston, LA 71272. Tel: 318-257-3593; Email: [email protected]

to ensure that managers behave in the best interest of shareholders by counteracting the effect of manage- rial risk aversion; however, strong managerial overop- timism can result in the undertaking of negative net present value projects and destruction of a firm’s value (Gervais, Heaton and Odean [2003]). An excessively favorable estimate of future outcomes for investments is the crux of this managerial overoptimism hypothe- sis. When managers have optimistic predictions of in- vestment outcomes, they are more inclined to finance with debt rather than equity. Confidence about the size of future outcomes makes managers unwilling to share future profits with new equity investors and make them more willing to issue debt rather than equity.

This study tests the managerial overoptimism hy- pothesis by examining post-financing stock perfor- mance for both debt and equity financing. If manage- rial overoptimism has a more significant effect on the choice between debt and equity financing and post- financing performance than manager attempts to time the market and take advantage of windows of opportu- nity for issuing equity, we expect worse stock perfor- mance following debt financing than following equity financing.

We focus on a sample of firms with rapid growth in assets and a corresponding need to finance those assets. By focusing on firms that require asset financ- ing, security issuance for other purposes can be largely eliminated. Furthermore, since studying long-term per- formance does not require identifying a particular is- suance date, our study is not limited to firms with ex- plicit announcements of security issuance. Rather than