Managerial Traits and Capital Structure Decisions

Abstract

This article incorporates well-documented managerial traits into a tradeoff model of capital structure to study their impact on corporate financial policy and firm value. Optimistic and/or overconfident managers choose higher debt levels and issue new debt more often but need not follow a pecking order. The model also surprisingly uncovers that these managerial traits can play a positive role. Biased managers' higher debt levels restrain them from diverting funds, which increases firm value by reducing this manager-shareholder conflict. Although higher debt levels delay investment, mildly biased managers' investment decisions can increase firm value by reducing this bondholder-shareholder conflict.

The impact of certain psychological factors of investors and managers on the capital structure

“…Therefore, in the case described above, regarding the perception of managers regarding the favorable outlook for business operations of the company, one should expect the decision that the necessary additional capital is to be raised by debt issuance, which would change the capital structure in terms of the higher level of debt (see examples 1 and 2 in the Chapter on Methodology). However, since managers of a company keep projects on introducing new products a secret, in order to put off the entry of competitors on the market, the same is true for the managers of competing companies, which creates an impression for both sides, which Bilgehan (2014) and Hackbarth (2008) call biases, overconfidence and optimism, in achieving better results than the competition. Namely, the projection of future events can be based on incomplete or even incorrect information, which by themselves represent a risk and can lead to wrong decisions, which can further cause the bankruptcy of the company.…”

“…In line with this, behavioral finance thus uses the theory based on psychology that would explain certain market anomalies (Bilgehan, 2014).Managers must choose between debt and proprietary capital when making financial decisions says Bilgehan (2014), therefore psychological biases that affect financial decision-making by the managers are responsible for inconsistency in relation to what is expected or preferred by investors. Hackbarth (2008) argues that optimism and overconfidence are described as reasoning in cases of uncertainty. He further argues that managers who perceive growth have tendency to achieve higher debt levels and more frequently recourse to issue new instruments of debt compared with managers who do not have such perceptions.…”

“…He further argues that managers who perceive growth have tendency to achieve higher debt levels and more frequently recourse to issue new instruments of debt compared with managers who do not have such perceptions. As a result of this, the behavior of managers can cause considerable variations in the capital structure no matter the characteristics of the industry which companies belong to unchanged (Hackbarth, 2008). Hackbarth further says that managerial features, in relation to the growth and risk perceptions, are very important for decision-making on the capital structure, such as the issue of debt issuance.…”

“…Stanišić et al (2012) say that debt to equity ratio (see examples 1 and 2 in the Chapter on Methodology) is an indicator that is often used in models for predicting bankruptcy and assessing solvency of companies. Hackbarth (2008) also argues that decisions regarding capital structure represent tradeoff between not just corporate taxes and bankruptcy costs, but also a conflict of interest among claimholders. Therefore, there is a disadvantage in terms of any qualitative or quantitative guide which would explain the interaction between agency conflicts and managerial traits.…”

“…By developing prospect theory which undoubtedly started the analysis of decision making under the risk as a consequence of the aforementioned psychological phenomena, Kahneman and Twersky (1979) established the basis of behavioral economics. Hackbarth (2008) proves that economists are focused on models in which market participants behave rationally and have homogeneous expectations. Nevertheless, a great number of researches in psychology show that people are inclined to excessive optimism and overconfidence.…”