Joint effect of CEO overconfidence and corporate social responsibility discretion on cost of equity capital

Abstract

The study investigates the joint impact of chief executive officer (CEO) overconfidence and corporate social responsibility (CSR) discretion on firms’ cost of equity capital (CoE). Overconfidence can cause CEOs to underestimate risks and to shift resources from CSR to risky projects. Such a concern could be relieved if investors were to observe the CSR efforts made by overconfident CEOs. This conjecture is empirically supported by the negative CoE effect jointly by CSR scores and CEO overconfidence. The joint effect is distinctive from the negative CoE effect introduced by CSR alone. Further evidence reveals that, for the firms operated by CEOs with greater overconfidence, investors charge lower CoE if CSR activities involve less managerial discretions. When CSR is decomposed into nondiscretionary CSR (NCSR) and discretionary CSR (DCSR) components, CEO overconfidence strengthens the differential CoE effect between the NCSR and DCSR, mainly through the more profound negative CoE impact of NCSR relative to DCSR. Taken together, we find that investors’ perceived risks associated with CEO overconfidence can be alleviated by diverting firm resources to CSR initiatives that have a connection to the firm’s economic factors.