Dividends and Managerial

Overcon�dence1

Balasingham Balachandran,#;a Suren Basov,# Michael Theobald�2

February 3, 2014

1We gratefully acknowledge the helpful comments and suggestions of RobertFa¤ and Tom Smith.

2# Department of Finance, La Trobe University, VIC 3086, Australia, *Mifran-the Associates, Warwicks, CV35 8HG, UK, aCorresponding author: e-mail:b.balachandran@latrobe.edu.au, tel. (61) 3 94791303, fax (61) 3 94793144.

Abstract

We analyse the direct impacts of managerial overcon�dence upon the div-

idend decision and demonstrate that the dividend levels and speeds of ad-

justment to target levels can increase when managers exhibit overcon�dence.

However, we demonstrate that the directional impact upon dividend levels

will depend upon the nature of the managerial overcon�dence. We consider

two components of managerial overcon�dence, pride and egotism, and show

that di¤ering degrees of investor bias can lead to reversals of this situation

with the result that the empirical results will be in�uenced by the relative

impacts of manager and investor related cognitive biases.

1 Introduction

While there have been signi�cant achievements in developing models of �-

nancial processes and phenomena from a behavioral perspective in the �nance

literature, in general, the important behavioral phenomenon of cognitive bi-

ases has yet not been fully incorporated into the corporate �nance literature.

In particular, its e¤ects on dividend/payout policy are not thoroughly stud-

ied. Merton and Rock (1985) argued that under asymmetric information

about the �rm�s current earnings the payment of dividends can increase the

value of the �rm if this provides signals as regards the �nancial health of

the �rm. However, DeAngelo, DeAngelo and Skinner (2008) argue that be-

havioral biases at the managerial level and the idiosyncratic preferences of

controlling stockholders, impact the dividend decision at least as strongly as

other better studied motives, such as signaling, clientele demands and tax

deferral bene�ts.1

1For some other explanations of dividend policy, see Shefrin and Statman (1984), whoin the one of the �rst papers that utilized behavioral �nance in the dividend area, developa framework that explains why investors exhibit a preference for dividends, based on thetheory of self-control advanced by Thaler and Shefrin (1981) and prospect theory developedby Kahneman and Tversky (1979). More recently, Baker and Wurgler (2004) develop a�catering theory�for dividends, wherein investor sentiment drives dividend decisions and,in Baker and Wurgler (2012) a model is developed with behavioral underpinnings forthe dividend decision on the basis of stockholders evaluating current dividends against areference point derived from past dividends.

1

This paper analyzes the joint impacts of managerial overcon�dence and

the signaling motive upon the level of dividends paid and the speed of adjust-

ment of dividends towards a target level. We demonstrate that the relation-

ship between managerial overcon�dence and dividends can change through

time and across market settings, with obvious implications for the internal

validity of the empirical studies of this phenomenon. Potentially, this sensi-

tivity is a contributory factor to the relatively weak relationships that have

been reported in the empirical literature with regards to the articulation

between managerial overcon�dence and dividend payments.

Extensive research has focused on managerial overcon�dence and opti-

mistic behavior in the corporate �nance literature. Heaton (2002) demon-

strates that optimistic managers believe capital markets undervalue their

�rm�s risky securities and may pass up positive net present value projects

that must be �nanced externally but overvalue their own corporate projects

and may wish to invest in negative net present value projects even when they

are loyal to shareholders. Malmendier and Tate (2005) show overcon�dent

CEOs overestimate the returns of investment projects, and invest more when

internal funds are su¢ cient, whereas if internal funds are not su¢ cient, they

will not issue new equity to increase investment in projects because over-

2

con�dent CEOs believe their �rm shares are undervalued by the market.

Furthermore, Malmendier and Tate (2008) show that overcon�dent CEOs

overestimate their ability to generate returns and as a result, they overpay

for target companies and undertake value-destroying mergers. Ferris, Jayara-

man and Sabherwal (2012) �nd that overcon�dence in�uences the number of

o¤ers made by a CEO, the frequency of diversifying acquisitions made, and

the choice of deal �nancing. More speci�cally, they �nd that overcon�dence

is an important factor in explaining the number of o¤ers made by a CEO.

However, there is a scarcity of research on the impact of managerial over-

con�dence on dividend policy. One of the few papers that addresses the issue

is Ben-David, Graham and Harvey (2007), who do not �nd any signi�cant

relation between the short-term overcon�dence measure based on the decile

ranking of individual volatility of short-term forecasts of the S&P 500 and

the propensity to pay dividends. They do �nd some support for a negative

relation between the decile ranking of the individual volatility of a long-term

overcon�dence measure based on the ten-year forecasts of the S&P 500 and

the propensity to pay dividends. Moreover, their study does not examine the

determinants of the dividend level or dividend payout ratio rather they exam-

ine whether the �rm pays dividends in the current year or not. Deshmukh,

3

Goel and Howe (2013), henceforth DGH, develop a model of the dynamic

interaction between CEO overcon�dence and dividend policy. Their model

predicts that (a) an overcon�dent CEO pays a lower level of dividends relative

to a rational CEO, (b) the di¤erence in the dividend payout between higher-

and lower-growth �rms is smaller in �rms managed by overcon�dent CEOs;

and (c) the stock price response to announcements of dividend changes is an

increasing function of the uncertainty about CEO overcon�dence. Consistent

with their prediction, they empirically �nd that the level of dividend payout

is lower in �rms managed by overcon�dent CEOs, and the di¤erence in the

dividend payout between higher-growth and lower-growth �rms is smaller

for �rms with overcon�dent CEOs. Furthermore, they document that the

positive relation between dividend payout and cash �ow is stronger in �rms

with overcon�dent CEOs. They also �nd that the magnitude of the posi-

tive stock price response to announcements of dividend increases is higher in

�rms in which there is greater uncertainty about the level of CEO�s overcon-

�dence. They assert that this �nding is consistent with their hypothesis that

dividends provide information about CEO overcon�dence.

We develop a model in which managers overcon�dence can take two dif-

ferent forms, to which we refer as pride and egotism. In the case of pure pride

4

the model reduces to that of DGH. In this version of the model overcon�dent

managers pay lower dividends. This feature is also shared by the model of

Heaton (2002) who showed that in this case managers will have incentives to

keep cash �ows inside the �rm and pay lower dividends. The mechanisms,

are however very di¤erent. In Section 5 we modify our basic model to al-

low the manager to be overoptimistic about the future prospects if the �rm

along the lines similar to Heaton (2002). In the opposite case of pure ego-

tism, overcon�dent managers pay higher dividends. In the general model,

the way overcon�dence a¤ects dividends is determined by the interaction be-

tween pride and egotism. The di¤erent components of overcon�dence may

have di¤erent e¤ects on the dividend policy. If one assumes that pride and

egotism are uncorrelated, then the estimate obtained by DGH of overcon�-

dence on the dividends level can be interpreted in our model as an unbiased

estimate of pride on dividends. If, on the other hand, pride and egotism are

positively correlated, then DGH underestimate the negative e¤ect of pride

on dividends.

We also consider the dynamics of the dividend setting process in a model

with pure egotism within a framework similar to the partial adjustment mod-

eling framework established by Lintner (1956). The main di¤erence of our

5

framework, from Lintner�s is that the dividend adjustment takes place in a

logarithmic functional form rather than in levels, which can be justi�ed by

decreasing absolute risk aversion on the part on the managers. We show that

egotistic managers are likely to adjust dividends more rapidly than those who

do not exhibit this bias. We further demonstrate that the interactions be-

tween managerial overcon�dence and investor expectations/estimations can

lead to di¤ering implications for the payment of dividends.

2 A model of overcon�dence

Overcon�dence, in general, arises from individuals believing that their

abilities are greater than is, in fact, the case and there is much supporting

evidence for its occurrence within �nancial markets and processes. From a

corporate �nance perspective, Heaton (2002) predicts that optimistic man-

agers will tend to have upward biased cash �ow forecasts, while Hilary and

Hsu (2011) �nd that overcon�dent managers display larger ex post earnings

forecast prediction errors. Furthermore, Hribar and Yang (2011) argue that

overcon�dent CEOs are more likely to issue optimistically biased forecasts

and/or underestimate the probability of random events. Therefore overcon�-

6

dence can have signi�cant impact on the corporate policies. Moreover, recent

papers by Ben-David, Graham, and. Harvey (2007) and Libby and Ren-

nekamp (2012) document that managerial overcon�dence is quite common

before proceeding to study its e¤ects on corporate policies. There exists also

su¢ cient indirect �nding concerning overcon�dence of the managers. Indeed,

Weinstein (1980) argued that the individuals who believe that outcomes are

under their control are or who are highly committed are more likely to be

overcon�dent. Managers are likely to have both high degree of commitment

and su¢ cient degree of control.

The available evidence in the psychological literature tends to suggest

that overcon�dence is more likely to manifest itself in tasks that require

judgment as is the case in the setting of dividends rather than in purely

mechanical situations and is more likely where feedback e¤ects are displaced

through time (Einhorn (1980)). There is also evidence available that, in

general, forecasters tend to underestimate error volatilities (Batchelor and

Dua (1992)). Furthermore, Lambrecht and Myers (2012) argue that, while

investment determines income and, thereby, payout, in a model incorporating

debt, the dividend payout does not necessarily need to be scaled back as a

consequence of project outlays, since borrowing/lending will achieve a similar

7

outcome. Essentially, from this perspective, managerial overcon�dence with

regards to investment could, itself, lead to a reduction in future earnings

error forecasts, and since the investment and dividend decisions are taken

jointly, it is not necessarily the case that dividends would need to be reduced

since funding could be achieved by debt.

Another dimension of overcon�dence is the in�ated estimation of the ef-

fect of dividend or other policy undertaken by a manager on investors. We

will start in this section by modelling the latter dimension of overcon�dence,

delaying incorporation of the former dimension until Section 4. The model

we develop in this section is similar to that of DGH. The crucial di¤erence

is that the external cash �ow, i.e. the amount new investors are willing to

invest in the �rm, is a¤ected by dividend policy, since potential investors

see dividend payments as a signal of �nancial health. The overcon�dence in

our model has two dimensions. First, following DGH, we assume that an

overcon�dent manager overestimates the precision of the signal she receives.

Second, we assume that a manager tends to overestimate the e¤ect her deci-

sion, in particular her dividend policy, has on investor behavior. The formal

model runs as follows. A manager is in charge of a �rm and acts fully in the

8

interests of shareholders.2 The number of shares is normalized to one (which

means we concentrate on the �nancial indicators per share) and the risk free

interest rate is assumed to be zero to simplify the presentation. The �rm

has a life that extends over three dates. At date zero the manager and the

market observe a noisy signal about the value of the projects available to the

�rm .At date one, the manager declares a dividend; this announcement may

attract some external �nancing. At date two, cash �ows are realized.

An investment I � 0 in the project at date one yields Y f(I) at date two,

where Y is the project quality, assumed to be a normally distributed random

variable with mean �y and precision3 �y; and function f(�) is assumed to be

increasing, twice-di¤erentiable, and concave. The manager observes a signal

s of the project�s quality at date zero. The quality signal is normally dis-

tributed with mean Y and precision �s. Within this structure, the expected

quality of the project conditional on the signal, y(s) is given by:

y(s) = E(Y js) =�y�y + �ss

�y + �s: (1)

Instead of the true precision of the signal the manager used her perceived

2We abstract here from the moral hazard consideration, which drive a wedge betweenthe interests of the manager and the shareholders.

3Precision of a random variable is the inverse of its standard deviation.

9

precision e�s; which is related to the true precision by:

e�s = a�s: (2)

In line with the overcon�dence literature, we say that the manager is over-

con�dent concerning the �rm�s prospects if a > 1. We will call this dimension

of overcon�dence �pride� to distinguish and facilitate our analysis.

The �rm starts with cash C > 0 at date zero, which can be thought as

the sum of its exogenous initial endowment, C0; and current earnings, E; i.e.

C = C0 + E: (3)

The manager also announces dividend payment, which attract external �-

nancing, F . Let us assume that

F = u�(E;D; z); (4)

where �(�; �; z) is a twice di¤erentiable, concave function, increasing in both

arguments, E and D;4 where z captures the managers direct e¤ort in raising

4The idea is that a potential investors sees both high current earnings and high divi-dends are indicative of high future earnings.

10

external �nance by means other than the dividend policy, and u is a collection

of random factors (other than the current earnings and dividends) that a¤ect

the investors expectations of the value of the �rm. E¤ort is costly and the

cost of e¤ort for the manager is bc(z); where c(�) is a strictly increasing,

di¤erentiable, convex function and b � 0. Intuitively, convexity of c(�) implies

that both the total and the marginal cost of e¤ort is increasing in z: From

technical point of view it makes the �rst order conditions for the choice of

e¤ort both necessary and su¢ cient.

The manager does not know u but forms her own expectation of the

investor responses according to:

F e = v�(E;D; z): (5)

External �nancing is costly, so the net cash received by the �rm from this

source is (1� �)F; where � 2 [0; 1). From the perspective of an outside ob-

server both u and v are random variables. We will assume that the manager

is overcon�dent concerning the ability of her policy to attract external �nance,

if v �rst order stochastically dominates u. Intuitively, the manager manifests

overcon�dence by expecting that the investment caused by the dividend pol-

11

icy will exceed any given level more often than it actually does. We will call

this further dimension of overcon�dence �egotism.�While the egotism and

pride dimensions relate to �rst and second moments respectively, they fur-

ther di¤er in terms of the random variables from which these moments derive.

The manager then solves the following constrained optimization problem:

maxI;D;z

(y(s)f(I) +D � F e � bc(z)) (6)

s:t:I = C �D + (1� �)F e; I � 0; D � 0; z � 0; F e = v�(E;D; z): (7)

One way to ensure that v �rst order stochastically dominates u is to

assume that

v = "u; (8)

where " > 1.5 With this assumption in our model the overcon�dence of the

manager is captured by the vector (a; "). It is plausible to assume that the

components of this vector are positively correlated across the population of

managers. Before analyzing the general case, let us consider two extreme

cases.

5Such parametrization is convenient, but not crucial for our results.

12

2.1 The manager directly controls external investment:

a model of pure pride

Let us consider a special case where the manager can directly decide the

amount of the external funds she raises. By direct control we mean that

amount of the external funds the manager raises is determined solely by the

managers e¤ort in raising funds and not by the �rm�s earnings, dividend

policy, or random factors. Formally this means that6

�D = �E = 0 (9)

in (4)-(5) and both u and v are degenerate random variables, which take

value of 1 with probability one. Let us also assume that b = 0; that is the

manager does not experience any cost of e¤ort from attracting the external

�nance. In that case the manager�s optimization problem becomes

maxI;D;F

(y(s)f(I) +D � F ) (10)

s:t:I = C �D + (1� �)F; I � 0; D � 0; F � 0; (11)

6A subscript denotes a partial derivative with respect to the corresponding variable.

13

which is exactly the problem considered by DGH, who established that the

optimal investment policy is a threshold policy and both the amounts of in-

vestment and of the external �nance raised are weakly increasing in overcon-

�dence concerning the �rm�s prospects (pride), while the dividends decrease

in pride. Note that since dividend policy is assumed not to a¤ect the in�ow

of the external funds the egotism dimension is irrelevant in this framework.

2.2 The manager does not have any direct control over

external investment: a model of pure egotism

The opposite situation occurs when the manager does not have any direct

control over the external investment, but can attract some funds via the

dividend policy adopted. Formally this means that �z = 0 in (4)-(5). Let us

further assume that �s = 0; i.e. both the manager and the market share the

same beliefs about the quality of the investment. In this case it is readily

apparent that the only dimension of overcon�dence that matters is egotism

as de�ned above. Let us further assume that

f(I) = I (12)

14

and both u and v have compact supports [u; u] and [v; v] respectively and

(1� �)�y > 1: (13)

Let us also introduce the following notation:

� = ((1� �)�y � 1)u; � = ((1� �)�y � 1)v. (14)

Assumption (13) guarantees that �; � > 0 and that � �rst order stochastically

dominates �. Finally let � = �y � 1 > 0.

The optimal dividend policy then is given by the solution to the following

optimization problem:

maxD(��(E;D)� �D); (15)

i.e. the manager chooses the dividend level to maximizes the change in the

cash �ow. The overcon�dent manager will however overestimate the ability

of her dividend policy to attract the external funds and solve a di¤erent

optimization problem, i.e. she will chooses the dividend level to maximizes

15

the change in perceived, rather than the real, cash �ow. Formally, she solves:

maxD(��(E;D)� �D): (16)

Note that if the mixed cross-partial derivative �DE > 07 then for both the

optimal dividend policy and the policy selected by the overcon�dent manager

dD=dE > 0; (17)

i.e. higher current earnings imply higher dividends. For a formal discussion

of the role of complementarity in comparative statics problems, see Topkis

(1987). Since condition (17) usually holds in the data, we will assume that

�DE > 0.

The �rst order condition is

��D(E;D) = � ; (18)

where the subscript denotes a derivative, � = � for the optimal dividend

policy and � = � for the policy selected by the overcon�dent manager. To

7This condition means that high current earning and high dividends are complimentarysignals, i.e. they reinforce each other as signals of �nancial health.

16

proceed further let us assume that �(E;D) is homogenous of degree one

(HD(1)). Formally, this assumption means that

�(�E; �D) = ��(E;D): (19)

If one interprets � as an exchange rate then the above condition simply states

that the relation between dividends, earnings and external �nance is currency

independent, which is a natural requirement. Alternatively, if � is the rate of

in�ation, then requirement of homogeneity of degree one implies no money

illusion. Assuming �(E;D) is HD(1):

�D(E;D) = '(D

E) (20)

and

� DE2'0(D

E) = �DE > 0; (21)

i.e. '0(�) < 0. Equation (18) now implies

D

E= '�1(

�

�) � g(�

�); (22)

where '�1(�) denotes an inverse function of '(�) and the properties of '(�)

17

imply that g(�) is increasing.

Since � �rst order stochastically dominates � and g(�) is increasing, the

distribution of dividends/earning paid by an overcon�dent manager will �rst

order stochastically dominate that paid by a rational manager. In particular,

an overcon�dent manager pays, on average, higher dividends. Let

s =D

E(23)

be the share of the earnings that the overcon�dent manager pays in dividends.

Our previous discussion can be summarized in the following Proposition:

Proposition 1 For any value d > 0 the probability that an overcon�dent

manager sets s < d is smaller than the probability for the case of a manager

who does not exhibit this cognitive bias.

In other words, an overcon�dent manager is more likely to set higher

dividends than a rational manager, ceteris paribus, in this egotistic setting.

We will further analyze the conclusions from this proposition in Section 4

where investor cognitive biases and di¤ering overcon�dence factors prevail.

18

3 Overcon�dence and dividend policy: a gen-

eral analysis

In the previous Section we have we analyzed two distinct overcon�dence

scenarios: pure egotism and pure pride. In this Section we will analyze the

general model and demonstrate the interplay between pride and egotism.

Simple algebraic manipulation of equations (6)-(7) allows us to re-write the

problem as:

max(y(s)f(C �D + (1� �)v�(E;D; z)) +D � v�(E;D; z)� bc(z)

s:t:z � 0; D � 0:(24)

The Kuhn-Tucker �rst order conditions are

8>>>>>><>>>>>>:v�D(y(s)f

0(I)(1� �)� 1) = y(s)f 0(I)� 1� �

v�z(y(s)f0(I)(1� �)� 1)) = bc0(z)� �

�z = 0; �D = 0; � � 0; � � 0

; (25)

where � and � are Lagrange multipliers for the non-negativity constraints.

First, we establish the following proposition, echoing Lemma 1 in DGH.

Proposition 2 If raising external funds is not costly (b = 0) then paying a

19

dividend and raising external �nancing are mutually exclusive at date 1.

Proof. Set b = 0 in (25) and assume to the contrary that z > 0 and

D > 0. Then the complimentary slackness conditions imply � = � = 0: But

then the second equation in system (25) implies

y(s)f 0(I)(1� �)� 1 = 0 (26)

and now the �rst equation in system (25) implies

� = �y(s)f 0(I) > 0; (27)

which is a contradiction.�

Intuitively, if e¤ort to obtain external funds is not costly, then the sig-

nalling motive in paying dividends is irrelevant, and so is the egotism of the

manager and we are fully within the framework of the DGH model. A third

Proposition can be developed as:

Proposition 3 Assume that f(�) is strictly concave and the manager�s opti-

mal policy includes a positive dividend payment. Controlling for the dividend

policy, an egotistic manager will have a tendency to select larger investment.

Proof. Since the manager pays dividends, � = 0 in the �rst equation in

20

system (25). We can re-arrange this equation as

yf 0(I) =1� v�D

1� (1� �)v�D: (28)

If v is linked to u by (8) with " > 1; equation (28) implies that f 0(I) selected

by egotistic manager is smaller than the one selected by the egotistic manager

is smaller than that selected by a manager who correctly predicts the e¤ects

of her policies. The result than follows from the concavity of f(�). For a

general form of �rst order stochastic dominance, an egotistic manager may

select a smaller investment for a particular realization of v; but v will tend to

dominate u in value, leading to a larger investment being typically selected

by the egotistic manager. �

This result is of course similar to that found in DGH, but note, however,

to obtain it the dividend policy had to be assumed to be �xed. If the dividend

policy is adjusted optimally, then as we have seen above, an egotistic manager

will be likely to set higher dividends, driving investment down. As a result,

the net e¤ect of egotism on investment is ambiguous.

21

4 Egotism and speed of adjustment

In Section 2 we considered the e¤ects that di¤erent dimensions of manage-

rial overcon�dence have upon the dividend policy. The model in the previous

section was, however, static and did not take into account how the manager

would adjust dividend payments to the exogenous target payout ratio, as for

example, in the Lintner (1956) partial adjustment model . In this Section we

study the e¤ects of the egotism of the manager on the speed of adjustment

of the dividends. To incorporate the dynamics of the dividend process in

the model of Section 2.2, let us �rst rewrite equation (22) with explicit time

indices

Dt

Et= '�1(

�

�t) � g(�t

�); (29)

and take logarithms of both sides to obtain:

lnDt = f(�t) + lnEt; (30)

where

f(�t) = ln g(�t�) (31)

22

If we de�ne the logarithm of the target dividend level, D�t ; by:

lnD�t = E(f(�t)) + lnE

�t ; (32)

where E�t is the long-run earning expectation in period t and assume that

lnE�t follows an AR(1) process with � 2 (0; 1); i.e.

lnE�t = � lnE�t�1 + e+ zt: (33)

Then

lnD�t = � lnD

�t�1 +m+ zt; (34)

where

m = e+ (1� �)E(f(�t))) (35)

and zt is a random disturbance with zero mean. Note that by the �rst

order stochastic dominance, parameter m will be greater for overcon�dent

managers than for the rational managers.

Let us now assume that managers partially adjust dividends to the target

23

ratio according to:

lnDt+1 = (1� �) lnDt + � lnD�t + vt;

8 (36)

where vt is a random disturbance with zero mean. Equation (36) with a time

lag of one period has the form:

lnDt = (1� �) lnDt�1 + � lnD�t�1 + vt�1: (37)

Subtracting equation (36) from equation (37) and taking into account (34)

one obtains:

lnDt+1�lnDt = ��(1��) lnD�t�1+m�+(1��)(lnDt�lnDt�1)+�zt+vt�vt�1:

(38)

Let us assume that � is close to one, i.e. there is strong persistence in

the long-run earning expectations and � is su¢ ciently small, meaning that

dividends adjust only slightly to the target level and stay close in expectation

8Lintner (1956) assumed that dividends, rather than their logarithms, adjust accordingto equation (17). Lambrecht and Myers (2012) prove that Lintner�s model correspondsto the optimal adjustment assuming managers have CARA utility function. Modelling inlogarithmic terms, however, captures better the optimal managerial behavior, assumingdecreasing absolute risk-aversion, e.g. CRRA.

24

to the previous one. One one can neglect the �rst term in equation (38) as

it contains a product of two small numbers and rewritten as

lnDt+1 � lnDt = m� + (1� �)(lnDt � lnDt�1) + �zt + vt � vt�1 (39)

i.e. in this approximation the logarithm of dividends follows an ARMA(2; 1)

process. Taking the exponentials of both sides of (38) one obtains:

Dt+1 = exp(�(m+ zt))D�tD

1��t�1 exp(vt � vt�1): (40)

Therefore, the speed of adjustment can be expressed as:

@Dt+1

@Dt

= � exp(�(m+ zt))D1��t�1

D1��t

exp(vt � vt�1): (41)

Note that the speed of adjustment is increasing in m as long as � + zt > 0.

Since � > 0 and the expectation of zt > 0; the latter condition is likely to be

realized, especially if the variance of zt is small. Therefore, an overcon�dent

manager is more likely to adjust the dividend levels more quickly than the

rational manager leading to the following Proposition:

Proposition 4 For � > 0 and zt > 0, an overcon�dent manager is more

25

likely to adjust dividends to target levels more rapidly than a manager who

does not exhibit this behavioral bias .

5 Heaton meets pure egotistic CEOs

We have shown that a manager who overestimates the e¤ects of her policy

on investors is likely to pay higher dividends conditional on earnings than

one that is not subject to this cognitive bias. This result, however, does

not imply that the manager who overestimates the e¤ects of her policy on

rational investors is always likely to pay higher dividends. Indeed, assume

That, conditional on earnings and dividend payment, rational investors would

have invested

IRt = uRt �(Et; Dt): (42)

The behavior of the actual investors is still given by (4), while the managerial

expectations are given by (5). Now, contrary to the above assume that ut

�rst order stochastically dominates vt; which in turn �rst order stochastically

dominates uRt ; i.e. both the manager and the investors overestimate the role

of the dividends as a signal of �nancial health, but the investors are more

sanguine than the manager. Following the same logic that led us to Propo-

26

sition 1, we can conclude that now the egotistic manager will be likely to

pay lower dividends than an egotistic manager who could have predicted the

investors estimate correctly, but higher dividends than the rational manager

facing rational investors. Optimism concerning the future prospects of the

�rm is potentially another dimension of managerial overcon�dence. Follow-

ing Heaton (2002), we will assume that a manager who su¤ers from such

a form of overcon�dence will have additional incentives to keep dividends

within the �rm. Formally, we will model this by postulating that dividends

a¤ects the change in the cash �ows in the following way:

�Ft = �Dt + (1� �)Dt � �Dt + It = �(� + �)Dt + It; (43)

where � is the optimism parameter. That is, the more optimistic the man-

ager, the more costly is her perception of the external �nancing. As a con-

sequence, therefore, she puts a higher subjective cost on paying out the div-

idends. Repeating the calculations that lead us to formula (22) one can

obtain

Dt

Et= g(

�t� + �

): (44)

27

Note that the two dimensions of overcon�dence a¤ect divided policy in dif-

ferent directions. While overestimating the e¤ects of one�s own policy tends

to increase dividend payments, overestimating the �rm�s prospects tends to

decrease it. Therefore, the net e¤ect will depend upon the kind of over-

con�dence of the manager. Importantly, in this section, then, we have

demonstrated how di¤ering dimensions and types of overcon�dence across

both managers and investors will lead to di¤ering implications as regards the

impacts upon dividends, in particular whether such biases will increase or

decrease the dividend levels paid out by an overcon�dent manager.

6 Conclusions

An understanding of the processes whereby dividend payouts are de-

termined and, indeed, why dividends may be paid, has long occupied the

academic �nance profession. Signi�cant advances were made by assuming

that economic agents behaved in a rational fashion and the literature has

evolved from establishing the conditions for dividend irrelevance to agency

and signalling related rationales for their existence. With the increasing

understanding of various cognitive biases and their impacts upon �nancial

28

markets and �nancial phenomena, it would appear to be highly appropriate

to analyze the impacts of such biases upon the dividend decision. In this

paper, we analytically investigate the impacts of managerial overcon�dence

upon the determination of dividends .We demonstrate that, within a plausi-

ble modelling framework involving managerial and investor interactions, that

the dividend payment level can be higher when managers are overcon�dent

and that the speed of adjustment to target dividend levels will be more rapid

within this scenario as compared to a market setting where managers are

not subject to this cognitive bias. However, we go further and demonstrate

that the resultant e¤ect of managerial overcon�dence upon dividend pay-

ments will be dependent upon the type of managerial overcon�dence and its

articulation with biases in investor estimates and expectations. That is, the

empirical studies that analyze the impacts of overcon�dent managers upon

dividend levels will be sensitive to these varying dimensions of overcon�dence

and market features and as these characteristics change through time (and

across market settings) the results and implications will similarly modify. As

such, then, the research designs may be enriched by including design features

that re�ect these changing phenomena, thereby increasing the internal va-

lidity of the empirical research. The relatively weak relationships that have

29

been discovered in the empirical research literature as regards the impacts

of managerial overcon�dence upon dividend levels may be a manifestation

of this sensitivity and a re�ection of these factors within the research design

may increase the strength and conclusions of the research.

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