Influence and Motivation of Overconfidence and Liquidity Risk on Corporate Debt Maturity

 

Liu Bai & Wang Yibo （Jilin University）

 

Abstract:As the main content of the decisions on corporate debt finance,debt maturity not only matters for the costs of financing, debt repayment plans and financial risk in firms, but also means a lot to creditors about the economic benefits and the risk of indebtedness. Most of the existing literature (e.g., immunization hypothesis, the agency theory and trade off theory) focus on industry or firm-level characteristics to explore the affecting factors of corporate debt maturity. However, the fact that the events of breach happened frequently in China’s bond market in 2016 calls for an alternative explanation in a new micro perspective beyond traditional financial theories.

More specifically, grounded in behavioral finance theory, we attempt to build a relationship between managerial overconfidence and corporate debt maturity. We suggest that the firms with overconfidence managers correspond to a shorter of debt maturity based on the following reasons: First, overconfident managers are the typical groups that are prone to cognitive biases. They tend to overestimate the profits of the projects while underestimate the corresponding risk, therefore, they have an unrealistic illusion towards future. More accurately, overconfident managers believe that firm value is underestimated and the securities suffer from mispricing. In line with this notion, compared with short-debt, the phenomena of mispricing are more severe for long-debt when firms require external financing. Second, overconfident managers are optimistic that good things are more likely to occur and hence, they claim they can exert a refinancing of short-debt in lower costs when the good news show up one by one. Third, the higher NPV for the projects in the perspective of overconfident managers means a shorter expected payback period of the projects than the actual time. As a result, these managers will prefer a higher level of short-debt to match the shorter payback period. 

To verify our predictions, we use the acts of increasing holds in equities of the management to capture managers’ overconfidence on the basis of data availability. Using a sample of China’s A-share non-financial listed companies covering the period from 2011 to 2015, we examine the effect of managerial overconfidence on corporate debt maturity. The prior literature focusing on corporate debt maturity hold the view that debt maturity and corporate leverage are endogenous and simultaneously determined, the estimator of OLS regression may be biased and not convincing. Therefore, the results in this paper are provided by the GMM regression for addressing the concerns about endogeneity. Further, we explore that whether liquid risk has significant implications for the relation between overconfidence and corporate debt maturity. Llast, we attempt to uncloak the motivations of this kind of irrational behavior. Our results show that managerial overconfidence is negatively associated with corporate debt maturity. Moreover, we find that the liquid risk do not have an inhibitory effect on this relation and hence, have limited power in the roles of influencing the financing decision-making of overconfident managers. Besides, we also reveal that firms with overconfident managers mean lower costs of debt finance, which could be attributed to that creditors consider the preference of overconfident managers to short-debt a positive sign for reducing the agency cost. 

The above findings have some practical implications. First, the monitoring and governance roles of internal formal mechanisms need to be given full play in firms. Our results highlight the need of keeping vigilant over the preference of overconfident managers to short-debt and correcting the irrational behavior caused by the managerial cognitive biases immediately. Second, firms need to control the liquid risk in a reasonable level on the basis of industry features and the financial status. A more effective monitoring mechanism on the funds and a better system of early-warning could help to prevent bankruptcy because of the local fracture in cash flow. Third, the structures of bond-market need to transform from demand-side to supply-side, which could contribute to make the market allocation work better in the governance of liquid risk. On the other hand, creditors need to know more about the financial status of the financing firms and have the ability to identify overconfident managers. It is necessary for creditors to remain alert to the firms that constantly have preferences for short-debt. Finally, our findings suggest that the effect of managerial overconfidence on corporate values isn’t purely negative at least for the costs of debt finance.

 

Key words:behavioral corporate finance; CEO overconfidence; liquidity risk; debt maturity structure; costs of debt financing