Investors’ perception of CEO overconfidence: evidence from the cost of equity capital

We cannot completely rule out the possibility that our overconfidence measure might reflect the negative relation between the cost of equity and the CEO’s objective assessment of firm future performance. Nevertheless, we acknowledge this as a limitation of this study.

We do not use a two-stage model to address endogeneity issue because CEO overconfidence is deemed as a personal trait that is not determined by firm characteristics.

A few studies examine creditors’ or auditors’ perceptions of CEO overconfidence (Hribar et al. 2013; Duellman et al. 2015; and Sunder et al. 2010).

Overconfidence is distinct from other, conventional characteristics of firm risk because it is an individual characteristic of a CEO rather than a characteristic of a firm.

We note that Sunder et al. (2010) examine the effect of CEO overconfidence on debt covenants. They find that firms with overconfident CEOs are associated with more restricted debt covenants. They also find weak evidence that overconfident CEOs face higher cost of debt. Together, they argue that creditors are more focused on managing the covenant design to reduce default risk associated with overconfidence. Our paper focuses on investors’ perceptions of CEO overconfidence manifested in cost of equity. While companies rely on both debt and equity capital, there are distinct differences between the two forms of capital. Creditors have priority over equity holders in cases of bankruptcy or liquidation. Creditors are concerned about the default risk. Their incentive is to ensure interest payments regardless of the profitability of the firm. In contrast, the equity holders bear higher risk and enjoy residual claims. Relative to debt holders, equity holders have higher incentives to pursue riskier projects that potentially generate more profits. Therefore, we project that equity holders are more likely to recognize the benefits of overconfident CEOs than debt holders.

Principal component analysis (PCA) is a multivariate technique that analyzes data in which observations are described by several inter-correlated quantitative dependent variables. Its goal is to extract important patterns of similarity of the observations (Abdi and Williams 2010). PCA often is used by accounting researchers to extract common information from multiple measures in order to better measure a theoretical construct (e.g. Li 2010; Hennes et al. 2014).

The industry median is calculated using a larger sample before our final sample attrition is conducted.

Ahmed and Duellman (2013) and Campbell et al. (2011) find that 35.1 and 34.1% of their firm-years have overconfident CEOs, respectively.

The correlation between OPTDELAY and OPTDELAY_NEGRET is 0.351.

\(- \frac{{\beta_{1} }}{{2\beta_{2} }} = \frac{(0.00276)}{2 \times ( - 0.00231)} = 0.597402597\).

The regression results of using the mean of CEO overconfidence are similar to the ones reported.

Prior literature suggests that managers’ overconfidence can affect their financing and cash holding decisions (Huang-Meier et al. 2016; Vivian and Xu 2017).

We also test whether a company’s high demand for external capital is associated with hiring a more overconfident CEO. We identify a sample of CEO turnover companies and partition the sample into the group with high needs for capital versus the group with low needs for capital prior to the CEO turnovers. Our proxy for company demand of external capital follows Dechow et al. (1996), which is an ex ante measure based on free cash flow. Free cash flows is defined as cash from operations minus the average three-year capital expenditures, and scaled by the beginning balance of current assets, all measured in the year prior to the turnover. Demand for external financing is high if free cash flows is less than the sample median; low otherwise. There are 844 observations that experience CEO turnover and have related data available. We observe a significant difference (two-tailed t test = 0.008) in the change of CEO overconfidence (that is, the succeeding CEO’s overconfidence level minus the departing CEO’s overconfidence level) between companies with high vs. low demand for external financing. The change in OCFACTOR is 0.216 higher for the high financing demand group, relative to the low demand group. Additionally, the correlation between free cash flows and change in OCFACTOR is − 0.121 and significant at the 0.05% level. These results are consistent with the proposition that firms with more needs to raise capital are more likely to hire more overconfident CEOs.

We use fixed parameters in the Gode and Mohanram (2003) model because there is a lack of literature that provides proper guidance on how to use varied parameters across observations. We acknowledge this as a potential measurement error.