Effects of Managerial Overconfidence on the Relationship between Corporate Risk-Taking and Firm Value

Abstract

1) This study investigates two issues pertinent to managerial overconfidence (hereafter, MOC) and risk-taking from the perspective of behavioral corporate finance: (1) Does MOC influence the relationship between corporate risk-taking and firm value? (2) Can the effects of MOC be moderated through certain internal and external governance or personal factors? Using the KOSPI for non-financial firms from 2002 to 2015, this study examines the issues by identifying the firms with MOC from the measurement variables that are related to both the determinants and outcome of MOC. The main findings are as follows. First, firms with overconfident managers tend to experience lower firm value compared to those with nonoverconfident managers because of their inappropriate or excessive risk-taking behavior. This finding suggests that in addition to agency problems, MOC can have negative effects on the relationship between risk-taking and firm value in Korean firms. Second, there are no significant internal or external governance control effects, such as outside directors’ control over obligations, a sound board of directors, the control of chaebols, a less-competitive indus-try, and less economic policy uncertainty over the negative effects of MOC, on the relation-ship between risk-taking and firm value. In contrast, the negative effects of MOC turn weak in terms of personal factors when the managers become older. These results show that con-trolling for the negative effects of MOC through internal or external governance mechanisms is not easy, even though these mechanisms may be helpful to control for the agency problem in Korean firms. Nevertheless, the results confirm that the effects of MOC depend on managers’ personal traits. This study shows that managers should be wary of their own overconfidence and restrain themselves from making irrational decisions. Furthermore, this study suggests that the board of directors needs to react against MOC and improve the board’s control over MOC in order to avoid its negative effects.