CEO overcaution and capital structure choices

Abstract

This paper develops and empirically tests a new version of the trade-off theory of corporate capital structure choices that accounts for CEOs' biased beliefs, with a focus on overcaution. We characterize the bias as a distortion of expected rates of return on equity and debt that, for Overcautious CEOs, are overestimated compared to a rational CEO. The theory shows that if CEOs have higher bias in equity, than in debt-value estimation, overcautious CEOs will choose lower levels of debt compared to rational CEOs, and, if the degree of overcaution is sufficiently high, they will adopt a zero-leverage policy.