The Effect of Managerial Overconfidence on Cost of Equity

This article investigates the economic impact of managerial overconfidence on investors’ resource allocation decisions in terms of cost of equity capital. I posit that managerial overconfidence affects cost of capital in two ways. First, managerial overconfidence results in poor accounting information quality and therefore increases information risk faced by shareholders that manifests in a higher cost of equity. Second, overconfident managers are more likely to invest in highly risky projects, which could increase business risk. Increase risk taking can reduce investors’ assessments of the distribution of firm’s future cash flows, which will be priced to the extent it is systematic. Based on the preceding arguments, I predict that the managerial overconfidence is positively associated with the cost of equity. This study presents new insights into the value investors place on managerial behavioral characteristics and provides a market-based assessment of the potential impact of an individual’s personality (overconfidence).

Project ID:PF10207-0730
External Project ID:NSC102-2410-H182-006