Heaton acknowledges that the opinions expressed here are his own, and do not reflect the position of Bartlit

In the context of a capital budgeting problem, we show how and when a manager’s overconfidence can be beneficial to a firm. Risk-averse managers sometimes choose to stay away from risky projects that would increase firm value. Overconfident managers overestimate their personal ability to reduce risk, and as a result may make capital budgeting decisions that are in the better interest of shareholders. Interestingly, this benefit to the firm does not necessarily result in diminished welfare for the manager. First, when compensation endogenously adjusts to reflect outside opportunities, moderate levels of overconfidence lead firms to offer the manager flatter compensation contracts that provide him with better insurance. Second, since overconfident managers overvalue the product of their information acquisition efforts, their bias naturally commits them to exert effort. This reduction of moral hazard problems sometimes makes an overconfident manager hireable when an equally skilled but rational counterpart would not be considered. Still, too much overconfidence is detrimental to the manager as it leads him to accept highly convex compensation contracts that expose him to excessive risk. ∗The authors would like to thank Franklin Allen, Jonathan Berk, Bruce Carlin, David Denis, Rober