Stakeholders Welfare and Executive Compensation Under Managerial Overconfidence

Abstract

This paper explores the impacts of managerial overconfidence on the structure of executive compensation, managerial effort, and the welfare of stockholders and managers. Our findings help explain two puzzling corporate finance phenomena. The viability of managerial overconfidence is perplexing since it has been shown to lead managers to erroneous and costly decisions. Our simulations indicate that managerial overconfidence induces managers to exert higher effort levels, and thus helps mitigate a well known agency problem. We construct a measure of the combined welfare of managers and stockholders and show that it is directly related to managerial overconfidence. This provides partial support to the persistence of the overconfidence behavioral bias. The optimality, and hence the viability, of the common practice of providing executive stock options with strike prices at-the-money is another debated issue since it is not based on well founded theory and its main benefits are tax advantages that expired in 2006. We show that the optimal strike prices for overconfident managers are in-the-money as those for realistic managers, but they are higher for the former, and therefore closer to the at-the-money strike prices provided in practice. We show that this implies that the tradition of offering executives stock options with at-the-money exercise prices is less damaging than hitherto believed.