CEO overconfidence, risk-taking, and firm value: Influence of incentive compensation and financial constraints

By using the data of firms listed on the three major US stock exchanges-the New York Stock Exchange, Nasdaq Stock Exchange, and American Stock Exchange-this study investigated (1) whether CEO overconfidence increases additional risk-taking and affects firm value, (2) whether high incentive compensation for overconfident CEOs increases additional risk-taking behavior and firm value, and (3) whether financial constraints reduce overconfident CEOs' additional risktaking and firm value. Our empirical results reveal significant differences in the variable data between the subsamples of firms with an overconfident CEO versus and those with a nonoverconfident CEO. The firms with an overconfident CEO had more additional risk-taking, higher firm value, and more financial constraints than those with a non-overconfident CEO did. CEO overconfidence had significant positive associations with additional risk-taking and firm value, indicating that CEO overconfidence has a positive effect on firm overinvestment. Although overconfidence sometimes distorts investment decisions, it also leads to risky but valuable investments. Offering incentive compensation can incentivize CEOs to engage in additional risktaking behaviors that increase firm value. This result indicates that offering a greater amount of incentive compensation encourages CEOs to take additional risks because they can gain higher compensation from making valuable investments that increase their firm's value. In this study, incentive compensation was more likely to motivate risk-taking leading to increase firm value in non-overconfident CEOs than in overconfident CEOs. That is, granting non-overconfident CEOs a high percentage of incentive compensation can align their interests with those of shareholders and encourage more rational risk-taking. Compared with firms with overconfident CEOs, those with non-overconfident CEOs that were subject to higher financial constraints exhibited a less significant decrease in additional risk-taking but a more significant decrease in firm value.

Automated summary

This study examines the impact of CEO overconfidence on additional risk-taking, firm value, and financial constraints using data from the three major US stock exchanges. The results show that CEO overconfidence has a positive effect on firm overinvestment and can be incentivized through offering higher incentive compensation. Additionally, it is found that non-overconfident CEOs with a higher percentage of incentive compensation exhibit more rational risk-taking behavior and alignment with shareholders' interests.