We analyse the effects of managerial overconfidence on financing decisions and firm value when investors face managerial moral hazard. We consider two cases. In the first case, the manager may have an incentive to exert an inefficiently low level of effort in running the business (‘managerial shirking’). The manager may issue high debt as a commitment device (the increase in expected financial distress drives him to a higher effort level). An overconfident manager overestimates his ability, and underestimates financial distress costs. Therefore, our first model predicts a positive relationship between overconfidence and debt. However, the effect of overconfidence on firm value is ambiguous, and depends which factor (the positive effect of higher effort, or the negative effect of higher debt and higher expected financial distress) dominates. In the second case, the manager has an incentive to use free cash flow to invest in a new pet project that may be value-reducing (the free cash flow problem). In contrast to the first case, overconfidence may result in a decrease in debt (the rational manager knows that the new project is value-reducing and uses high debt to commit not to invest in it, while the overconfident manager perceives the new project as value-increasing, and reduces debt in order to make the investment). Again, the effect of overconfidence on firm value is ambiguous, since a project that may have been value-reducing under a rational manager may indeed be value-increasing under an overconfident manager, as the overconfident manager exerts higher effort. We conclude our analysis by conceptualising a model of “excessive life-cycle debt sensitivity due to managerial overconfidence” not previously explored in the literature
