CEO Overconfidence and Corporate Investment - Essay Example

The paper is divided into seven sections, in the first section; Ulrike and Tate have developed a model that predicts that managerial overconfidence leads to positive investment-cash flow sensitivity. The second part they give the data that they used and the third section explains the building of overconfidence instruments and the substitute instruments. The fourth section gives the evidence they collected that supports the idea that CEO’s overconfidence increases the sensitivity of investment to cash flows, the fifth section deals with evidence to support the proposition that CEO overconfidence is more in the equity dependent firms.

Section 6 examines the relationship of CEO’s overconfidence to other personal characteristics and section seven is the conclusion. In the first section, they use a 2 period model that shows the effects of a CEO’s overconfidence on a firms investments in an well-organized market. In coming up with the model, they assume that asymmetry of information and agency relationships does not affect the investment decisions of a manger and that the only factor affecting the decisions is the CEO’s overconfidence. . In section 2, the paper uses data of 477 large publicly traded firms in the United States between the years 1980 and 1994, in order to compare the data on how the CEO’s managed their personal account and the firms account, more information was derived from COMPUSTAT database.

The data measured include investments as capital expenditure, cash flow as earnings before extra ordinary items plus depreciation, and capital as property, plants and equipments, and investments and cash flow are normalised with the beginning of the year capital. In addition, information on the CEO’s employment histories is collected where the CEO’s are classified into three groups based on their education history, that is, those with technical education, those with finance education and those with other degrees In the results, the y found out that the out of the 113 CEO’s who qualified the holder 67 selection criteria, 115 of them displayed characteristics of overconfidence in their personal portfolios.

From the results there were minimal cases correlation between overconfidence and the firm or the CEO’s characteristics, this relationship was found to be opposite for different subsamples or the different measures of overconfidence used. Some of the alternative explanations to the measures that Gate and Ulrike gave include the following. Inside information, this is where a CEO may decide to lower risk exposure of a company due information that he has on the future stock prices, this information will also influence the investment cash flow sensitivity.

The second alternative is signalling where a company would be passing information to the capital markets that its prospects are better than of rival firm, signalling in most