Overconfidence, Compensation Contracts, and Capital Budgeting

Overconfidence, Compensation Contracts, and Capital Budgeting

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Article ID: iaor201112095
Volume: 66
Issue: 5
Start Page Number: 1735
End Page Number: 1777
Publication Date: Oct 2011
Journal: The Journal of Finance
Authors: , ,
Keywords: management
Abstract:

A risk‐averse manager’s overconfidence makes him less conservative. As a result, it is cheaper for firms to motivate him to pursue valuable risky projects. When compensation endogenously adjusts to reflect outside opportunities, moderate levels of overconfidence lead firms to offer the manager flatter compensation contracts that make him better off. Overconfident managers are also more attractive to firms than their rational counterparts because overconfidence commits them to exert effort to learn about projects. Still, too much overconfidence is detrimental to the manager since it leads him to accept highly convex compensation contracts that expose him to excessive risk.

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