The Effect of Cognitive and Emotional Biases on the Capital Structure Decisions: A Literature Review

Abstract

Each decision-making process is an important cognitive and emotional process

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

“…Capital structure is the most significant issue in the corporate finance theory (Bilgehan, 2014). In accordance with the references in the field of finance, there are many approaches that define the theory of capital structure, of which the most important are, as Besley and Brigham (2015) argue, the trade off theory, created in 1958 by professors Modigliani and Miller, and the pecking order theory, which is a consequence of asymmetries in information.…”

“…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.…”

“…However, in contrast to this behavioral finance which is based on human psychology, there is an alternative approach which calls into question definitions of the classical finance on economic rationality. In particular, psychological studies have found that people have unreasonably high confidence in their own decision making, which essentially means that most people have exaggerated confidence in their abilities (Bilgehan, 2014). It is particularly important that behavioral finance uses psychology and similar disciplines to explore why individual solutions, often deviate from the strictly rational choices.…”

“…It is particularly important that behavioral finance uses psychology and similar disciplines to explore why individual solutions, often deviate from the strictly rational choices. As Bilgehan (2014) further states, most people are aware that emotions affect financial decisions, thus analysis of behavioral finance expands the role of biased insights when making decisions. The greatest number of studies in behavioral finance refers to the behavior of investors, not only them, but also to the behavior of managers in financial decisionmaking in companies.…”

“…The greatest number of studies in behavioral finance refers to the behavior of investors, not only them, but also to the behavior of managers in financial decisionmaking in companies. The latest behavioral finance theories give an explanation how biases such as overconfidence and optimism can affect corporate decisions (Bilgehan, 2014). According to the definition of Hersh Shefrin, which Bilgehan (2014) cites, bias is nothing else than a predisposition towards errors if there is influence of some basic belief.…”