Managerial Beliefs and Corporate Financial Policies ∗

We measure the impact of individual managerial beliefs on corporate financing. First, managers who believe that their firm is undervalued view external financing as overpriced, especially equity. We show that such overconfident managers use less external finance and, conditional on accessing risky capital, issue less equity than their peers. Second, CEOs with Depression experience have less faith in capital markets and lean excessively on internal financing. Third, CEOs with military experience pursue more aggressive policies, including heightened leverage. CEOs’ press portrayals confirm these differences in beliefs. Overall, measurable managerial characteristics have significant explanatory power beyond traditional capital-structure determinants. ∗We are indebted to Brian Hall, David Yermack and John Graham for providing us with the data. We thank Malcolm Baker, Rudi Fahlenbrach, Michael Faulkender, Murray Frank, Dirk Hackbarth, Dirk Jenter, Jeremy Stein, Ilya Strebulaev, Avanidhar Subrahmanyam, Jeffrey Wurgler and seminar participants at the Berkeley, Calgary, Columbia, Helsinki School of Economics, Insead, MIT, Rotterdam, Stanford, UCLA, USC, Wharton (Applied Economics), Zurich and at the AEA, AFA, FEA, Frontiers in Finance (Banff), IZA Behavioral Economics of Organizations, and Olin Corporate Governance conferences for helpful comments. Nishanth Rajan provided excellent research assistance. Ulrike Malmendier would like to thank the Coleman Fung Risk Management Research Center for financial support. An earlier version of this paper was titled “Corporate Financial Policies With Overconfident Managers. ” What are the primary determinants of firms’ financing decisions? Traditional theories emphasize firm-, industry-, and market-level explanations, such as the trade-off between tax deductibility of interest payments and bankruptcy costs, or asymmetric information between firms and the capital market (Miller (1977); Myers (1984); Myers and Majluf (1984)). These theories explain a significant portion of the observed variation in capital structure. Yet, recent research identifies a large degree of firm-specific stickiness in capital structure that is not a clear prediction of any traditional theory (Lemmon et al. (2008)). Moreover, even in their modern dynamic implementations, traditional theories do not easily explain why firms with similar fundamentals make different financing choices. In this paper, we study the role of managers’ beliefs and personal experiences in explaining the remaining variation. A growing literature on manager effects shows that individual top-level managers significantly affect corporate decisions and performance, above and beyond firm-, industry-, and market-specific determinants (Weisbach (1995); Chevalier and Ellison (1999); Bertrand and Schoar (2003)). However, we know less about the specific managerial characteristics that matter (and why), likely due to the difficulty of linking observable characteristics to specific individual beliefs. This challenge, in turn, makes it hard to establish a causal impact on corporate decisions. In this paper, we measure capital-structure relevant beliefs revealed by CEOs’ personal portfolio choices (overconfidence) and related to personal experiences early in life (Great Depression, military), and we confirm their impact on capital structure choices. First, we consider managers who overestimate the future cash flows of their firms and, hence, believe that their firms are undervalued by the market. We denote such managers as overconfident. We show that overconfident managers view external financing to be unduly costly and prefer to use cash or riskless debt. Thus, they choose low levels of risky debt relative to available interest tax deductions. And, conditional on having to raise risky capital, they prefer risky debt to equity, since equity prices are more sensitive to differences of opinions about future cash flows. Second, we consider variation in managers’ personal histories that is likely to generate differences in beliefs. Existing evidence suggests that individuals are the most affected by seismic events early in life (see, e.g., Elder (1998)). We identify the two biggest shocks that are likely to be formative experiences for our sample CEOs: growing up during the Great Depression and serving in the military. Depression CEOs tend to have less faith in external capital mar-