On reflection, it doesn’t seem any easier to deal with irrational managers
than irrational investors. It is true that many firms have mechanisms in
place designed to solve agency problems and to keep the manager’s mind
focused on maximizing firm value: giving him stock options for example,
or saddling him with debt. The problem is that these mechanisms are un-
likely to have much of an effect on irrational managers. These managers
thinkthat they are maximizing firm value, even if in reality, they are not.
Since they think that they are already doing the right thing, stock options
or debt are unlikely to change their behavior.
In the best known paper on managerial irrationality, Roll (1986) argues
that much of the evidence on takeover activity is consistent with an econ-
omy in which there are nooverall gains to takeovers, but in which man-
agers are overconfident, a theory he terms the “hubris hypothesis.” When
managers think about taking over another firm, they conduct a valuation
analysis of that firm, taking synergies into account. If managers are over-
confident about the accuracy of their analysis, they will be too quick to
launch a bid when their valuation exceeds the market price of the target.
Just as overconfidence among individual investors may lead to excessive
trading, so overconfidence among managers may lead to excessive takeover
activity.
The main predictions of the hubris hypothesis are that there will be a
large amount of takeover activity, but that the total combined gain to bid-
der and target will be zero; and that on the announcement of a bid, the
price of the target will rise and the value of the bidder will fall by a similar
amount. Roll examines the available evidence and concludes that it is im-
possible to reject any of these predictions.
Heaton (2002) analyses the consequences of managerial optimism
whereby managers overestimate the probability that the future perfor-
mance of their firm will be good. He shows that it can explain pecking
order rules for capital structure: since managers are optimistic relative to
the capital markets, they believe their equity is undervalued, and are there-
fore reluctant to issue it unless they have exhausted internally generated
funds or the debt market. Managerial optimism can also explain the puz-
zlingly high correlation of investment and cash flow: when cash flow is low,
managers’ reluctance to use external markets for financing means that they
forgo an unusually large number of projects, lowering investment at the
same time.
Malmendier and Tate (2001) test Heaton’s model by investigating
whether firms with excessively optimistic CEOs display a greater sensitivity
of investment to cash flow. They detect excessive optimism among CEOs by
examining at what point they exercise their stock options: CEOs who hold
on to their options longer than recommended by normative models of opti-
mal exercise are deemed to have an overly optimistic forecast of their stock’s
future price. Malmendier and Tate find that the investment of these CEOs’
62 BARBERIS AND THALER