Chapter 3
This paper mainly focuses on how manager's overconfidence impact on the performance of the company. The manager here is the person who has the power to make investment decisions in the company. According to the Chinese Corporate Law, the power distribution principle of Chinese listed company is: the shareholders meeting to determine the company's overall goals and general policy, which is the 'macro decision-making' power. In the other hand, the daily investment and financing decision-making power lies in the hand of the Board of Directors and senior management. Hence, the 'manager' in this paper defined as the CEO of the listed company.
This article choose the 250 Chinese listed companies follow the company's operating revenue order, and the study interval from 2009 to 2011. In order to make the research result more accuracy and objectivity, the selection of sample follow the following principles:
To ensure the interval data longitudinal comparability, eliminate the companies listed after 2008;
Due to the own characteristics of financial companies, eliminate financial companies;
To avoid abnormal data affect the final result, eliminate ST1 class and data missing companies.
Finally, the sample size is 214 companies and there are 642 observations in total. The data in this paper mostly collected from OSIRIS, missing data supplemented by Thomson One Banker. Excel was performing data collection, filtering and sorting functions; a number of quantitative analytical techniques will be applied via regression test by using the statistical software package: OxMetrics.
Behavioral finance thinks that 80% of investment success or failure is decided by psychological factors. Behavioral finance also believes the manager's self-attribution bias and other psychological factors can lead to they make the wrong financing decisions. Overconfident managers tend to think the market underestimate the value of their company. They then to issue some new shares to dilute the existing shareholders' rights, so overconfident managers prefer debt financing. In some behavioral finance studies can be found overconfident managers and completely rational managers have different effect on capital structure. Overconfident manager usually overestimate the growth of pre-tax profit of the company and underestimate the risk of the investment project, thus they tend to choose the project with higher financial leverage and heavy debt. Compare to equity financing, overconfident managers are more likely to debt financing, this may results capital structure not be optimal for the firm.1
As can be seen from the literature review, overconfident managers normally misjudge their own ability and accuracy of their judgment, which overestimate the profit of the investment project and underestimate the risks they are going to face. In addition, when a overconfident manager has overinvestment impulse, the enterprises' own fund can not fully meet its investment needs, they usually to achieve the financing purpose via radical debt financing, which leads to excessive level of debt. Thus the risk of corporate finance has increase dramatically; also reduce the growth of corporate performance.
Base on above analysis, the first hypothesis of this paper is:
H1: CEO's confidence level and corporate financing have a positive correlation.
The model set up to test this hypothesis shows below:
Variables
CEO's Overconfidence (OC):
There are couple of approaches to measure CEO's overconfidence, but they all not suitable for Chinese listed companies, here will introduce a new way to measure the confidence level of CEO. From psychology side, a person's confidence level and his age has positive relation, the older the more confident. From behavioural financial side, Malmendier, Tate and Yan (2011) argued that the early-life experience has influence on managerial overconfidence and affect corporate finance. They concluded that empirical evidence supports CEOs who have Depression experience and military experience both have effect of their decision-making, but in different way. CEOs have a Great Depression experience are more cautious, in another word, less confidence. On the contrary, CEOs that used to service in the military are more aggressive, more confidence about their decision. Combine both psychology and financial aspects, consider a CEO overconfidence as his/her age over ?? which is the average age of all the observations and he/she was not a member of board in a company in 1998. We choose the year 1998 here because of the Asian Financial Crisis happened that year.
Dependent Variable
Leverage (Lev) ratios are useful for reviewing the capital structure of a firm. These methods analyse the breakdown of debt and equity and help in the determination of cost of capital. The default leverage ratio from Thomson One Banker is considered here, which is:
This ratio compares the firm's debt to its permanent capital and the results provide an indication of the firm's ability to take on additional leverage.
Independent Variables:
Investment opportunity (Q): Myers(1977) pointed out the early literatures estimate a firm's liabilities depends on the ratio of debt book value to the equity book value or the debt to the book value of total assets ratio. Modern financial theory thinks this ratio should take market value into account would become more reliable. Most investors pay a lot of attention on the assets already in place; however this kind of assets value is not the most key component of the market value of the firm. So Myers divides market value into two parts: one is the market value of current business assets, another part is the present value of future investment opportunities. The current business should have relative more debt financing than growth opportunities, which means enterprise growth opportunities and financing leverage is negatively correlated. Smith and Watts (1992), Barclay and Smith (1995a, 1996b), and Goyal (2001) also proved the higher the growth opportunities the lower leverage ratio. This paper use Tobin'Q ratio to indicate future investment opportunities, as it is the most widely used in the financial analysis.
Tangibility (Fix): Tangible assets provide the best collateral for loans, and are expected to support the debt, which can be used as collateral. Frank and Goyal (2003) claimed the more collateral firm have, the higher the leverage. If companies have an abundance of plants, equipment and inventory, be the best value of the collateral (Scott, 1977). Stulz and Johnson (1985) maintain that company's funded secured debt can increase in value of the company, also can reduce the problem of lack of investment. Tangible assets are less susceptible to asymmetric information and usually have a higher value of intangible assets in bankruptcy (Johnson, 1997). Moreover, moral hazard problem can be avoid when the company offers tangible collateral. Tangibility measure as:
Firm Size (Size): Frank and Goyal (2003) believed firm size has positive related to leverage. A company's leverage can be affect by company size via the default risk and bankruptcy costs. Rajan and Zingales (1995) thought compare to the small firm, large firm disclose more information to creditors and outside investors. Large firm has strong ability to withstand risks and can carry out diversified business hedge risk to enhance profitability to raise its debt capacity. So it is hard to tell the correlation between firm size and leverage. Firm's size measured as follows:
Firm Profitability (PRF) ratios give an insight into how the firm makes its operational decisions and analyses the stability of the firm's earnings. A company with strong profitability is better positioned to cope with adversity. From past researches, scholars have different opinion about the relationship between firm's profitability and leverage. Myers and Majluf (1984), Titman and Wessels (1988) and Rajan and Zingales (1995) all support firm's leverage declines with the profitability rises. Alternatively, Jensen (1986) thinks that the manager in high level of profitability more likely have overspending problem, high debt is a good way to control this problem. The operating profit margin ratio used in this study to measure firm's profitability.
Performance ratios are a useful measure of a company's performance in that it portrays how well the management of the firm is using the company's capital to generate profits. For this performance measure, we use Return on Equity which considers the net profit of the firm divided by its equity.
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