CEO Overconfidence and Capital Structure Decisions: Evidence from India

• Published in: Vikalpa 2022-03, Vol.47 (1), p.19-37
• Main Authors: Mundi, Hardeep Singh, Kaur, Parmjit
• Format: Article
• Language: English
• Subjects: Capital structure; Debt financing; Decision making; Long term debt
• ISSN: 0256-0909; 2395-3799
• DOI: 10.1177/02560909221079270

Executive Summary Capital structure decisions are vital for firms. Existing theories on capital structure partially explain the difference in capital structure decisions of identical firms. Researchers have integrated psychology with finance in recent years to explain the difference in capital structure decisions better. To help practitioners and academicians understand the role of psychology in capital structure decisions, this article focuses on CEO overconfidence and its influence on equity versus debt financing, short-term versus long-term debt financing, and level of debt financing concerning tax shields. Indian CEOs are unique in their leadership style, values and beliefs. Overconfidence among CEOs of S&P BSE 200 firms is measured using the press coverage of CEOs, and this proxy depicts how the press portrays CEOs. An extensive search on CEOs in relevant search engines helped measure overconfidence among CEOs. The results from regression models document that overconfident CEOs prefer debt over equity and short-term debt over long-term debt. In addition, overconfident CEOs are found to not avail the full benefits of tax shield and follow a conservative debt policy. The presence of bias of overconfidence among CEOs distorts optimal decision-making and deviates capital structure decisions from trade-off theory and pecking order theory of capital structure. The evidence on external versus internal financing helps explain the biased preference of overconfident CEOs for debt and short-term financing. The biased beliefs lead CEOs to form high expectations of cash flows. Overconfidence among CEOs is found to significantly influence capital structure decisions. The robustness of the results corroborates existing findings and documents the influence of behavioural biases on corporate decision-making.