Managerial behavioral biases are receiving growing attention in corporate finance. Recent theories have illuminated how biases like overconfidence and optimism can affect various corporate decisions (e.g. Manove and Padilla, 1999; Bernardo and Welch, 2001; Heaton, 2002; Van den Steen, 2004; Coval and Thakor, 2005; and Goel and Thakor, 2008).
There is also a nascent empirical literature that has exposed interesting evidence of the effects of managerial behavioral biases. Malmendier and Tate (2005) find that overconfident CEOs invest more aggressively, and Malmendier and Tate (2008) show that overconfident CEOs are more likely to engage in value-destroying mergers. Ben-David, Graham and Harvey (2007) find that firms with overconfident CFOs maintain higher debt ratios and are less likely to pay dividends or repurchase shares. Puri and Robinson (2007) document that optimistic individuals exhibit systematically different choices compared to others, such as holding less diversified portfolios. Graham, Harvey, and Puri (2007) find evidence consistent with the view that optimistic CEOs expect better future performance.
This paper focuses on a new implication of managerial optimism. In particular, I examine the market’s response to dividend change announcements. Optimism is defined here as the manager’s propensity to overestimate her firm’s expected future earnings. Since an optimistic manager is more bullish about her firm’s earnings prospects than a rational manager, her private assessment of future earnings is more positive than the assessment of her rational counterpart when the news is good and less negative when the news is bad. This suggests that if investors cannot distinguish between rational and optimistic managers, assessment-dependent actions of optimistic managers will provide bigger positive and smaller negative surprises relative to investors’ expectations (or prior beliefs).
This intuition can be captured in a simple signaling framework in which some firms are run by rational managers and some by optimistic managers who think they are rational. Investors do not know who is rational and who is optimistic, but they share common prior beliefs about the likelihood of a manager being optimistic. Each manager receives a private signal about her firm’s future earnings and adjusts the firm’s dividend in response. While the rational manager interprets each signal correctly, the optimistic manager has an upward bias in her assessment of this private signal and thus overestimates future earnings. The optimistic manager’s dividend change thus conveys to investors more positive private information about her firm’s future earnings than does the dividend change of a rational manager. As a result, the market reacts more positively to a given dividend increase by an optimistic manager.
One might be tempted to think that this means optimistic managers will pay higher dividends than rational managers. However, this is only true if all firms start out with the same prior dividend level, all managers receive the same signal and investors have the same prior beliefs about all firms’ future earnings. When firms are observationally heterogeneous cross-sectionally in terms of their previous dividend levels and also investors’ prior beliefs about their earnings (and hence about the dividend change), then it is possible that a firm with a smaller dividend change may be conveying more positive new information about future earnings to the market than a firm with a larger dividend change.
Nonetheless, if an optimistic manager and a rational manager both announce the same dividend change, there is on average more good news being communicated by the optimistic manager’s dividend change than by the rational manager’s dividend change. In other words, the market will associate a bigger positive surprise (or a smaller negative surprise) with the optimistic manager’s dividend change. The prediction then is that, holding fixed the size of the dividend change, dividend changes announced by an optimistic manager are associated with higher announcement returns than those announced by a rational manager.
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