Darryl Laws

  What robustness checks were conducted? Malmendier and Tate discuss the robustness of their results to the changes in the empirical model. Simply stated they focused upon the baseline estimates of binary regression equation provided in regression method use (above). First, they considered; Is the Option in the Money? Their CEO stock option long holder measure of overconfidence is they classify a CEO as overconfident if he ever holds his company stock option(s) until expiration. The less an option is in the money, the less delayed exercise indicates likely overconfidence. As a robustness check of their measure, they require that the option that is held until expiration be at least x% in the money at the beginning of its final year. They vary x between 0 and 100 by increments of 10. As they increase x, the classification as overconfident becomes more restrictive. Concurrently, they hold the definition of rational option exercise behavior constant. (Example: they require that the CE...

  Log likelihood. Had I conducted the research I would have chosen to use log likelihood statistic to assess and to depict the  deviance, or -2 log-likelihood (-2LL) statistic . The deviance is basically a measure of how much unexplained variation there is in our logistic regression model the higher the value the less accurate the model. It compares the difference in probability between the predicted outcome and the actual outcome for each case and sums these differences together to provide a measure of the total error in the model. This is similar in purpose to looking at the total of the  residuals  (the  sum of squares ) in linear regression analysis in that it provides us with an indication of how good our model is at predicting the outcome. The -2LL statistic (often called the deviance) is an indicator of how much unexplained information there is after the model has been fitted, with large values of -2LL indicating poorly fitting models. The  deviance...

  The measurement they use is the coefficient odds ratio (log likelihood statistic). The odds ratio is crucial to the interpretation of logistics regression. It is an indicator of the change in odds resulting from a unit change in the predictor. The resulting statistic is based upon comparing observed frequencies with the predicted model. When the predictor variable is categorical the odds ratio is easier to explain. This is referred to as the likelihood ratio Field, 2018, pg. 614)  There are two very different approaches to answering the goodness of fit question. One is to get a statistic that measures how well you can predict the dependent variable based on the independent variables. These kinds of statistics are referred to as measures of predictive power . Typically, they vary between 0 and 1, with 0 meaning no predictive power whatsoever and 1 meaning perfect predictions. The other approach to evaluating model fit is to compute a goodness-of-fit statistic. Ordinarily the ...

  Translation…the manager’s perceived valuation of the merged company minus what he must give up to target shareholders minus the perceived loss due to dilution must exceed his perceived value of A without the merger. Their model denotes the perceived additional merger synergies as be ∈ R++,12. Hence, they decompose  bV (c) into (2) bV (c) = bVA + VT + e + be – c Acquisition Decision of a Rational CEO. In comparison to the overconfident CEO Malmendier and Tate (2008) compare him / her to the takeover decision of a single rational CEO. They start with the assumption that the acquiror has all bargaining power and  must pay VT for the target. If he offers an amount c < VT of cash financing (or other non-diluting assets), target shareholders demand a share s of the merged company such that sV (c) = VT − c. Since the CEO acts in the interest of current shareholders, he chooses to conduct the takeover if and only if V (c) −(VT −c) > VA. Malmendier and Tate denote the me...

  Their model is binary because there are two kinds of variation that they use to identify the effect of overconfidence on acquisitiveness, cross-sectional and within-company variation. Malmendier and Tate (2008) solve their regression equation using three estimation procedures: 1) a logit regression, makes use of both types of variation, 2) a logit regression with random effects, also makes use of both types of variation but, it explicitly models the effect of the firm, rather than the CEO, on acquisitiveness. I noted that if the estimated effects of overconfidence in the logit equation are due to company effects, they should expect to see a decline in their estimates if they include random effects. The remainder of their solution uses a logit regression with fixed effects. This regression equation makes use only of the second type of variation, the effect of overconfidence on acquisitiveness using only variation between overconfident and rational CEOs within a particular firm. Fo...

  Regression method used . Malmendier and Tate use a binary logistic regression methodology to predict categorical outcomes from categorical and continuous predictors when predicting which of the two categories a CEO was likely to belong to; overconfident CEOs (independent variable) verses rational CEOs. The logistic regression or logit model method is appropriate as it is often used to model dichotomous outcome variables such as the dependent variable: CEOs holding their stock options to maturity and CEO’s overly acquisitiveness. In the logit model the log odds of the outcome are modeled as a linear combination of the predictor variables. When OLS regression is used with a binary response variable it becomes known as a linear probability model and can be used to describe conditional probabilities. However, the errors (residuals) from the linear probability model violate the homoskedasticity and normality of errors assumptions for OLS regression, resulting in invalid standard erro...

  In concluding their research Malmendier and Tate (2008) investigated the capital market’s perception / reaction to the merger / acquisition decisions made by overconfident CEOs. They used a standard event study methodology to show that outside investors react more negatively to the announcement of a bid if the CEO is overconfident.  Sample. Malmendier and Tate’s (2008) used the sample to test ad validate their propositions. The sample was comprised of 477 large publicly traded U.S. companies between the years 1980 to 1994. To be included in the in the sample required that a company must appear at least four times on one of the lists of largest US companies compiled by Forbes magazine between 1984 to 1994. IPOs were excluded. The core of their data set provides detailed information on the stock ownership and set of option packages, including exercise price, maturity, and number of underlying shares for the CEO of each company in each year. From this data they were able to ...

  Previous literature in corporate finance shows that risk averse CEOs should exercise stock options well before expiration due to the suboptimal concentration of their portfolio in company-specific risk. Malmendier and Tate (2008) classify CEOs as overconfident when they display the opposite behavior. Example: if they hold company stock options until the last year before expiration. This behavior suggests that the CEO is persistently bullish about his company’s future prospects. Malmendier and Tate (2008) find that overconfident CEOs are more likely to conduct mergers / acquisitions than rational CEOs at any point in time. The higher acquisitiveness of overconfident CEOs on average suggests that overconfidence is an important determinant of merger / acquisition activity. Further, the effect of overconfidence on merger activity comes primarily from an increased likelihood of conducting diversifying acquisitions. Previous literature suggests that diversifying mergers are unlikely to...

  Malmendier and Tate (2008) examine the extent to which over-confidence can help to explain merger / acquisition decisions and various characteristics of the deal itself. They find that overconfident CEOs are; 1) more likely to pursue acquisitions when their firms have abundant internal resources, 2) are significantly more likely than other CEOs to undertake a diversifying merger and 3) that overconfident CEOs use cash to finance their mergers / acquisitions more often than rational CEOs. They have developed a unique model for CEO overconfidence that shows the impact of overconfidence on merger / acquisition decisions. Their model empirically and quantitively test the predictions on a data set of large U.S. companies from 1980 to 1994. They use the CEOs’ personal portfolio decisions to measure overconfidence, they find that overconfident CEOs conduct more mergers / acquisitions and, in particular, more value-destroying mergers / acquisitions. They prognosticate that these effects ...

  Overconfidence . Overconfident decisions often indicate a loss of contact with reality and an overestimation of one’s own competence or capabilities, especially when the person exhibiting it is in a position of power. Doukas and Petmezas (2007) argue that managerial overconfidence results from a self-attribution bias. Specifically, overconfident CEOs feel that they have superior decision-making abilities and are more capable than their peers. The presence of these cognitive biases encourages CEOs to emphasize their own judgment in decision making and to engage in highly complex transactions such as diversifying acquisitions that are not necessarily homogenous with exiting assets of their company. Because of their overconfidence, these CEOs tend to underestimate the risks associated with a merger or overestimate the possible synergy gains from a business combination.  The analysis of overconfidence relates several branches of behavioral economics and psychology literature. Fi...

  Mergers and Acquisitions. Literature on mergers and acquisitions identifies three main motivations for takeovers; first the creation of synergies so that the value of a new combined entity is greater than the sum of its previously separate values (Bradley,1988; Dyer, 2004 and Tease, 1986), the second motivation exists because of agency issues (Eisenhardt, 1989) between managers and shareholders. Jensen (1986) suggests that managers may rationally pursue their own objectives at the expense of shareholder’s interests, and the third motivation for takeovers is managerial hubris (Roll, 1986) and behavioral bias. Roll’s hubris hypothesis suggests that managers of acquiring firms make valuation errors because they are too optimistic about the potential of combined synergies in a buyout or takeover. As a result, CEOs often overbid for target firms to the detriment of their stockholders. Thus, there are two main theories; 1) rational responses to agency costs and 2) irrational response t...

    I chose this particular article to review because the topic aligns with my dissertation research topic; What causes irrational human behavior in mergers and acquisitions and to what economic extent does these behaviors impact the premium price paid / sold for the acquisition?   The author’s two independent variables that are relative to my research question are: CEO overconfidence and CEO hubris. Furthermore, their article fits the academic paper selection criteria because it uses a binary logistic regression method as the main empirical methodology to look at the impact on the dependant variable, the premium price paid for acquiring companies.  Introduction. The biggest challenge for the analysis of CEO overconfidence is; “How to construct a plausible measure of overconfidence?” Biased beliefs naturally defy direct and precise measurement (Malmendier and Tate, 2004). Malmendier and Tate’s (2004) previous work proposes two approaches to measurement; 1) the fir...

  Who Makes Acquisitions? CEO Overconfidence and The Market’s Reaction .   Ulrike Malmendier and Geoffrey Tate, 2008, Journal of Financial Economics, Elsevier Abstract. Overconfident CEOs over-estimate their ability in numerous ways. One of which is their over estimation to generate returns (ROE, cash dividends) to their companies. Often, they undertake mergers or acquisitions that destroy their own company’s value. Overconfident CEOs often perceive outside financing cost to be over-priced.  Malmendier and Tate (2008) classify CEOs as overconfident when they hold their options in their own company’s stock until expiration. The authors find; 1) that these CEOs are more acquisitive on average, particularly via diversifying acquisitions transactions which are not germane to their core business, 2) the effects are more ostensible on firms with abundant cash and untapped debt capacity, 3) that the measure of overconfidence used, media (press) coverage as confident or optimisti...