226
MANAGERIAL OVEROPTIMISM
for the managerial overoptimism hypothesis and the windows of opportunity hypothesis.
Managerial Overoptimism Hypothesis
A corollary to the signaling hypothesis is the sug- gestion that managers who are overoptimistic about their firm’s ability to generate wealth-creating projects and believe their equity to be undervalued prefer to is- sue debt rather than equity. Heaton [2002] formalizes the model examining the effect of managerial overop- timism on corporate decisions. He suggests that when managers are overoptimistic about the firm’s prospects, they perceive their firm’s risky securities to be under- valued and, to avoid issuing underpriced securities, prefer debt issues to equity issues. Also, since overop- timistic managers overvalue the projects available to them, they undertake some projects that are negative net present value projects even though their intentions are to act in the best interests of their shareholders.
Recent empirical studies support Heaton’s [2002] hypothesis that overoptimistic managers prefer debt financing to equity financing. Malmendier, Tate and Yan [2006] examine a sample of Forbes 500 firms and find that overconfident CEOs are more likely to issue debt than equity. Furthermore, Marciukaityte [2006] finds that firms obtaining substantial debt financing have higher discretionary accruals than firms obtaining substantial external equity financing. She suggests that high discretionary accruals at the time of debt financing are due to managerial overoptimism.
Poor stock performance following equity and debt issues (e.g., Ritter [1991], Loughran and Ritter [1995] Spiess and Affleck-Graves [1995 and 1999], Datta, Iskandar-Datta and Raman [2000]) suggests that the market is overoptimistic about the value of firms ob- taining external financing. For overoptimistic man- agers to believe that their firm is undervalued, they need to be more overoptimistic than the market about the value of their firm. Behavioral studies suggest that at least the most overoptimistic managers are even more overoptimistic about the value of their firms than the market. These studies show that overopti- mism and overconfidence are not just characteristics of laypeople; managers are also likely to be overcon- fident. After testing overconfidence among groups of managers from different industries, Russo and Schoe- maker [1992] conclude that “every group believed it knew more than it did about its industry or company” and more than 99% were overconfident. Also, Langer [1975] and Weinstein [1980] show that people tend to be more overoptimistic about outcomes when they be- lieve they have control of those outcomes. Of course, managers do have more control of their firms than investors do. Furthermore, desirability of outcomes and commitment to outcomes increase overoptimism (Frank [1935], Weinstein [1980]). As managers’ com-
pensation and reputation are affected by the perfor- mance of their firms, managers are likely to be more strongly committed to their firms than investors. Even higher intelligence does not seem to protect against overoptimism; Klaczynski and Fauth [1996] show that overoptimism is actually more severe among people with superior intellectual abilities. Furthermore, as some of the factors affecting managerial and market overoptimism may be the same, e.g., past performance of the firm or past performance of similar firms, man- agers are likely to be the most overoptimistic when the market is overoptimistic. Thus, the most overoptimistic managers will perceive their firm to be undervalued by the market even when it is overvalued.
Managerial optimism for individual projects can ex- tend to overconfidence in the ability to add value to any acquired assets, including acquiring an entire firm. Within the context of a merger, the managerial over- confidence is referred to as “Managerial Hubris.” It is an explanation for acquiring firms paying substantial premiums to acquire targets, where the premiums are in excess of managerial ability to add value to the tar- get assets. The methodology of this study incorporates merger activity within its definition of firm growth, since asset growth can be accomplished either through capital expenditure for new assets, purchase of existing assets from another firm, or mergers. Likewise, debt or equity issued to finance a merger or acquisition is in- corporated within the methodology of this study. Such debt or equity issuance will not be accompanied by an announcement of a new security offering even though the effect is the same whether securities are issued via a public offering or in conjunction with a merger or acquisition.
Windows of Opportunity Hypothesis
If managers are reluctant to issue underpriced se- curities, then equity issuance would occur primarily when mangers perceive these securities to be over- priced. The managerial practice of issuing overpriced equity receives empirical support in the study by Ritter [1991] of stock underperformance after initial public equity offerings (IPOs). Ritter finds that IPO firms un- derperform matching firms for three years after the first day of public trading. Such underperformance is even stronger for firms going public in years with heavy IPO activity. These findings, Ritter suggests, “indicate that issuers are successfully timing new issues to take ad- vantage of ‘windows of opportunity.”’ (p. 4) If investors are overoptimistic about the firm value in certain pe- riods, making equity issues in those periods allows a firm to raise the same amount of money with an issue of fewer shares, taking advantage of new shareholders. This hypothesis suggests that investors are overopti- mistic about the value of a firm at the time of the
