Overconfidence In Corporate Finance

1415 Words6 Pages
In this chapter, the relevant literature that contributes to the research will be reviewed. First, the value creation of the mergers and acquisitions will be discussed. After explaining the overconfidence concept from the psychology view, the hubris theory and the overconfidence in the content of corporate finance will be discussed. In the end of this section, the measures of the overconfidence and the hypotheses derived based on the literature views will be proposed. 2.1. M&A and Value Creation Mergers and acquisitions transaction are conducted when two or more entities transferred or combined their ownerships. Numerical literature has documented the economic and financial significances of M&A transactions. Firms conduct M&As to increase…show more content…
The research explains the takeover phenomenon that bidding firms pay too much for their targets due to the managerial hubris. The hubris theory explains the common phenomenon in M&A that the target firms seem to gain while acquirers tend to lose. Overconfidence CEO tends to overestimate their own managerial abilities and the synergy gains created from the M&A transactions (Roll, 1986). Due to the auction-like transaction of mergers, the bid goes to the firm that provides the highest price. Since the estimated price of the overconfident manager is higher than the intrinsic value of the bid, the winner overpaid the deal and losses money (Thaler, 1988). This phenomenon is also referred as the winner curse. After the hubris theory has been proposed, Hayward and Hambrick (1997) examined the relationship of CEO’s hubris and the premium paid in acquisitions. The study found the strong positive relationship between four CEO overconfidence indicators and the takeover premium. And the effect of CEO hubris on the magnitude of acquisition premium paid by acquirers is strengthened if the hubris CEO lack of sufficient monitor from the board of the…show more content…
Since overconfidence CEO overestimate the firm value and believe market undervalues their firm stocks, they consider the equity finance overly costly. In the end, overconfident CEOs tend overestimates the return and overinvest when cash is abundant, and they tend to cut the budget when firms are cash constrained. To further understand the effect CEO overconfidence on value creation for the acquirers in M&As, Malmendier and Tate (2008) investigated 477 public firms in U.S. from 1980 to 1994 and analyzed the market reaction of the bidding firms when the acquisitions announced. The study first used the “Long holder” of the option as a proxy for CEO overconfidence and concluded that overconfident CEOs conducted acquisition more frequently in firms with abundant cash and created less value than rational CEOs. The odds of making the acquisitions by “Long holder” CEOs are 0.195, which is 1.65 times of the odds for the rational CEO (0.118). The research also found the significantly more negative market response to merger announcement for overconfidence CEOs (-90 basis point) than non-overconfident CEOs (-12 basis point). Besides Longholder CEOs are particularly likely to do diversifying acquisitions. In addition, they employed the press portrait to measure the CEOs’ personality and confirmed the
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