Managerial Hubris, Firm Expansion and Firm Performance:

Evidence from China

Fuxiu Jiang
School of Business
Renmin University of China
Beijing, China

Gregory R. Stone*
College of Business Administration
University of Nevada, Reno
Reno, NV 89557

Jianfei Sun
College of Business Administration
University of Nevada, Reno
Reno, NV 89557

Min Zhang
Guanghua School of Management
Peking University
Beijing, China

* Corresponding author. Mail Stop 028, Department of Managerial Sciences, University of Nevada, Reno,
89557., Tel.: (775) 682-9174; fax: (775) 784-1769. E-mail address: gstone@unr.edu (Greg Stone).
 Managerial Hubris, Firm Expansion and Firm Performance:
Evidence from China

Abstract

Examining Chinese publically traded firms between 2002-2005, we find that managerial

overconfidence is positively correlated with the rate of firm expansion. In particular,

overconfident managers tend to internally expand firms in an aggressive manner. Also a

negative, though not statistically significant, relationship exists between managerial

overconfidence and M&A activity. Lastly, this paper examines the relationship between

managerial overconfidence and firm performance and finds that managerial

overconfidence decreases firm profitability due to overinvestment.

JEL Classification: G34

Keywords: Managerial overconfidence; Firm expansion; Firm performance; China;

Emerging Markets; Agency Theory

1
 Managerial Hubris, Firm Expansion and Firm Performance:
Evidence from China

1. Introduction

Jensen (1986) posits that CEOs have a strong desire to expand their firm or

“empire build.” This phenomenon may be more pronounced in emerging markets like

China where the market for corporate control is less developed and cross-shareholding

may create greater agency issues. In particular, an emphasis on “growing bigger and

stronger” has enjoyed great popularity among Chinese executives in recent years and is a

frequent topic in the Chinese popular press. Some enterprises have even included this

expression into their company’s charter. Though the rate of firm expansion in China has

been rapid, the impact of CEO overconfidence on firm expansion and firm performance,

to the best of our knowledge, has not been previously examined. 1

Using data from Chinese listed firms during the period 2002 to 2005, we analyze

the impact of managerial overconfidence on firm expansion and performance. The results

indicate that managerial overconfidence is positively related to firm expansion and that

overconfident managers are more likely to choose internal rather than external (M&A)

expansion. We believe the choice of internal expansion is due to the institutional

background which exists in China. A simultaneous equations model is used to investigate

the causal relationship between managerial overconfidence and firm expansion and the

results are robust. Lastly, we find that overconfident managers negatively impact firm

performance and that this may be due to the rapid rate of expansion or overinvestment.

1
Measured as the percentages of new investment to total assets, firm investment rates was 6.05%, 6.00%,
5.71%, and 5.17%, while the growth rate of investments was 36.83%, 27.67%, 44.95%, and 16.66%,
respectively, from 2002 to 2005.

2
 This study contributes to the existing literature in several ways. First, we examine

the relationship between a firm’s growth and expansion in a unique way. While many

previous studies have focused on a firm’s expansion projects from the perspective of

agency theory (e.g., see Harford (1999), Jensen (1986)), efficient markets (e.g., see Baker

et al. (2003)) or mergers (e.g., see Malmendier and Tate (2008)) this investigation takes a

different approach focusing on managerial overconfidence within the context of

behavioral corporate finance. That is, though managers are destroying value, they believe

they are acting in the best interests of the shareholders.

This paper also contributes to the growing body of literature on emerging markets.

This study investigates Chinese firms and in addition to China being a developing

economy, it also has a unique institutional background. Most Chinese firms are State-

Owned Enterprises (SOE) 2 . Because of the government’s controlling interest in most

firms, only a limited market for corporate control exists and private shareholders cannot

discipline managers in the way that occurs in less centralized firms. This may allow

managers to act in ways which do not maximize shareholder value with less fear of

shareholder retribution and managerial overconfidence may play a more important role in

the firm’s operations than in more developed economies. Lastly, this paper adds to the

body of literature by showing that overconfident Chinese managers are more likely to opt

for internal investment, rather than pursue M&A activity, a result inconsistent with the

existing literature.

The rest of the paper continues as follows: Section 2 reviews the related literature.

Section 3 discusses the hypotheses. Section 4 describes the data. Section 5 presents the

2
In 2005, the State was the largest shareholder in 69% of all Chinese listed firms. The government owned
at least 30% of the outstanding shares in 74% of publicly listed firms and over 50% of the outstanding
shares in 40% of all listed companies.

3
empirical results and Section 6 concludes the paper.

2. Literature Review

The extant literature on firm expansion is substantial. Information asymmetry

theory suggests that expansion of the firm is dependent upon a “pecking order” of capital.

If overvalued, the firm is likely to issue equity to raise capital for expansion; if the firm is

undervalued, the firm is likely to repurchase shares (e.g., see Myers (1984), Masulis and

Korwar (1986)). Agency theory suggests that managers expand firms for their personal

benefit, using expansion to further increase job entrenchment or improve managerial

reputation (e.g., see Jensen (1986), Narayanan (1985)). Other studies suggest that firm

expansion is determined by a commodities life cycle (Mintzberg (1978)), transaction

costs ((e.g., Williamson (1975), Khanna and Palepu (2000)), or synergistic considerations

(Weston (1997)).

Managerial overconfidence has also been investigated as a reason for firm

expansion. Overconfidence refers to the psychological bias of people to overestimate the

probability of their success and underestimate the probability of their failure (e.g., see

Wolosin et al. (1973), Langer (1975)). A great deal of psychology literature suggests that

overconfidence is common (e.g., see Weinstein (1980), Alicke (1985)). In addition to

studies by psychologists, financial economists have investigated overconfident managers.

A number of previous studies have used various proxies to estimate managerial

overconfidence. Malmendier and Tate (2003, 2005) define an overconfident manager in

the following three ways: (i) the manager holds a 5-year long option and has at least two

chances to exercise 67% of his options within the period, but chooses not to; (ii) the

manager does not exercise their stock options when first able to do so or; (iii) the net

shares held by CEO increases during the sample period. Malmendier and Tate (2003) and

4
Doukas and Petmezas (2006) also define overconfident CEOs as those who undertake

more than five mergers or acquisitions in a five-year period.

Hayward and Hambrick (1997) define overconfidence using the statements of

CEOs, collected in the mainstream media. 3 The statements are divided into 6 categories

and assigned a score representing managerial overconfidence, the higher the score the

more overconfident the CEO. Malmendier and Tate (2003) and Brown and Sarma (2007)

adopt similar methodologies. Hayward and Hambrick (1997) suggest that the higher the

CEOs salary, relative to other managers, the more important his position and hence the

more overconfident he is likely to be. A CEO’s salary, relative to that of the company’s

highest paid managers, represents the level of overconfidence. Lastly, Hayward and

Hambrick (1997) suggest that the better a firm’s performance over the previous 12

months, the more overconfident the manager will be.

Lin et al. (2005) argue that overconfident managers overestimate their earnings

forecast and the difference between a manager’s forecast and actual earnings can be used

to measure overconfidence, the greater the difference, the more overconfident the

manager. Cooper et al. (1988) show that U.S. entrepreneurs estimate the probability of

success of “other” firms at only 59%, while simultaneously estimating the probability of

the success of their own firm at 81%. Overall, some 66% of the sample firms failed.

Landier et al. (2004) find that 56% of the French entrepreneurs believe they will survive

while only 6% of them worry about their future. Merrow et al. (1981) report that

managers underestimate the cost of energy investment projects by half making expansion

appear more profitable than it turns out to be. Statman et al. (1985) obtain similar results

in studies of other industries, suggesting that managers are overly optimistic in their
3
Outlets such as the “New York Times.”

5
forecasts and that overconfidence is not limited to the energy industry.

Lin et al. (2005) examine the relationship between managerial overconfidence and

investment in Taiwan and find similar results; overconfident managers undertake more

M&A activity. Doukas and Petmezas (2006) and Brown and Sarma (2007) examine the

relationship between managerial overconfidence and mergers and find a positive

relationship between a manager’s confidence level and the number of mergers undertaken.

They also find that the returns from the mergers undertaken by overconfident managers

are lower than the returns of less confident managers. Malmendier and Tate (2005) also

show that more overconfident managers will undertake more mergers.

Several papers have examined managerial overconfidence in Chinese firms.

However, these studies differ from ours as they look at contexts other than M&A activity

and firm performance. Also, because of the difficulty in obtaining Chinese data, these

studies use only a single measure of managerial overconfidence. We improve upon this

methodology by using two measures to establish the robustness of our results. Using

stock options held by managers as a proxy for managerial overconfidence, Hao et al.

(2005) find results similar to those of Malmendier and Tate (2005). Yu et al. (2006) use a

prosperity index as a proxy for managerial overconfidence and find that overconfident

managers are more likely to use a larger percentage of debt financing.

Other papers have proposed theoretical explanations for managerial

overconfidence. Roll (1986) proposes the “Hubris” hypothesis and analyzes the impact of

overconfident managers on mergers. Roll argues that overconfident managers

overestimate the return mergers will produce and believe mergers will create synergistic

effects. Consequently, managers partake in mergers that add no value. Heaton (2002)

6
develops an investment distortion model based on managerial overconfidence. He

combines managerial overconfidence and free cash flow into a model and shows that

managerial overconfidence can lead to either overinvestment or underinvestment in

different free cash flow circumstances.

To summarize, while a great deal of firm expansion literature exists, few studies

examine the impact of managerial overconfidence on firm expansion and the influence of

managerial overconfidence on firm performance. This is likely due to the difficulty of

gathering data on the key variable, overconfidence. In China, due to issues of data

availability this issue is difficult to investigate and has resulted in many papers that were

more qualitative in nature rather than quantitative. We address this issue by using the

methodologies employed in studies on developed markets, thereby extending the current

body of literature to less developed markets.

3. Research Hypothesis

Overconfident managers overestimate returns and underestimate risks. Hence,

when determining expansion strategies, overconfident managers pay less attention to risk

and estimate their chances of success too optimistically, resulting in excessively rapid

expansion. Unlike agency theory, the theory of managerial overconfidence assumes that

managers are loyal to their shareholders and they are maximizing shareholder value (e.g.,

see Heaton (2002)). The rapid pace of firm expansion occurs not because managers are

self serving, trying to increase their personal utility, but rather because they are

overconfident in their decisions and subsequently destroy firm value.

Chinese managers may be more overconfident than their peers in other countries

for several reasons. Confucianism has long dominated Chinese culture. A major tenet of

7
Confucianism is that hierarchical relationships are to be highly respected. In China, the

company’s leader, often the chairman, possesses near absolute authority. Further, the

concept that the leader’s decision is final is deeply rooted in Chinese customs. The status

endowed by Chinese traditional culture upon leaders may make firm executives

overconfident. Contributing to this problem, because China is an emerging market and

undergoing an economic transition, firms lack effective external monitoring and

disciplining mechanisms.

In summary, in the context of an environment with an imperfect legal system, an

ineffective supervision mechanism, where Chinese managers underestimate risks and

overestimate their capabilities, our first hypothesis is:

H1: Overconfident managers expand firms more rapidly than less confident managers.

Expanding firms may be constrained by management, capital or both and these

constraints may significantly influence a firm’s performance. This problem will be more

acute when managers are overconfident. Overconfident managers overestimate their

ability to create value. As a result they overestimate the returns they can achieve and may

destroy firm value in the process. Our second hypothesis is that rapid firm expansion

chosen by overconfident managers results in poorer firm performance.

H2: The expansion by overconfident managers negatively affects firm performance.

4. Data and variable definitions

8
4.1 Data

We use data from Chinese listed firms from both the Shanghai and Shenzhen

Stock Exchanges. Data is from the China Center for Economic Research (CCER) and the

China Stock Market and Accounting Research (CSMAR) database. The sample period is

from January 1, 2002 to December 31, 2005. To eliminate the impact of IPOs, firms with

an IPO date after December 31, 2001 are eliminated from the data set. An additional

reason for restricting the study to 2002 and later is because earnings data is unavailable

prior to this date and earnings data is used in the forecasting section of this paper. In

addition, financial firms, Special Treatment (ST) and Particular Treatment (PT) firms are

eliminated from the data set as well leaving 895 firms each year over 4 years generating

panel data of 3,580 observations. 4

Mergers and Acquisitions (M&A) data is collected during the 2002-2005 period.

There are 6,810 mergers or acquisitions initiated by listed firms. Of those, 5,703 are

eliminated leaving 1,107 mergers or acquisitions. 5 Merging each firm’s M&A activity

gives us 436 firm year observations. The earnings forecast data is manually collected

from the TianXiang database. Other data is from CCER and CSMAR.

4.2. Managerial overconfidence

One of the more ambiguous aspects of this study is to define and quantify

“managerial overconfidence” and this may be the reason there is little direct empirical

research on this topic.

4
Special Treatment (ST) and Particular Treatment (PT) firms are firms whose stock is restricted. These
firms usually have severe financial problems and are thus specially designated by the China Securities
Regulatory Commission.
5
The reduced number of observations is due to the prevalence of tunneling or propping (see Zengquan
(2005)) in which M&A activity is conducted by the controlling shareholders and government which
damage the company’s value. A connected M&A or transaction, also called affiliated transaction, means
that one party of the transaction directly or indirectly controls or can significantly affect the other party.

9
 Two variables are used to examine measure managerial overconfidence, the first

variable is similar to the one used by Lin et al. (2005) the difference between the

manager’s forecasted earnings and the firm’s actual earnings. Beginning in 1990 on the

Shanghai Stock Exchange and 1991 in the Shenzhen Stock Exchange, Chinese managers

began forecasting their firm’s future earnings. 6 Since then, the China Securities

Regulatory Commission (CSRC) has issued several rules regulating monitoring earnings

forecasts. In particular, in 1996 and 1997, the CSRC issued a series of regulations that

punished firms if earnings forecasts were greater than 10% higher than actual earnings.

In addition to the CSRC, in 2001, both the Shenzhen Stock Exchange and the

Shanghai Stock Exchange published regulations on the disclosure of earnings forecasts

by the firms. According to regulations of the Shenzhen Stock Exchange, listed firms were

required to disclose earnings forecast or performance warnings prior to July 31st if they

expect to suffer a significant change in earnings, either positive or negative. According to

the regulations of the Shanghai Stock Exchange, earnings forecast or performance

warnings are required if the listed firm is expected to lose or suffer a change of over 50%

of their profits from the previous year and their causes must be disclosed 30 days prior to

the end of financial year. In 2002, quarterly financial reports were required to make the

same declarations and at that time, many firms started making earnings forecasts. To

prevent listed firms from manipulating earnings forecasts, the CSRC published a series of

regulations to further restrict biases in earnings forecasts.

Our sample is restricted to firms that disclose quarterly, semi-annual and annual

earnings forecasts in their financial reports. Following Lin et al. (2005) we define

managers as overconfident if the actual earnings are lower than the forecasted earnings at
6
Shenzhen Stock Exchange was established in 1991 and Shanghai Stock Exchange was established in 1990.

10
least one time during the sample period. 7 Additional firms are removed from the data set

according to the following criteria: i) sample firms that finance within one year after its

disclosure of forecasted earnings. This is to eliminate firms which may be managing their

earnings in order to improve their bargaining position with potential sources of capital

(Lin et al., 2005); ii) to eliminate the impact of top executive turnover, we delete sample

firms whose general managers or directors were replaced during the sample period. Table

1 summarizes the data set used.

[Insert Table 1]

Of the 895 firms, 423, 495, 475, and 561 firms made earnings forecast at least one

time during the 2002-2005 period, respectively, leaving 1,954 total observations. The

numbers of firms whose earnings are lower than the forecast at least once was 28, 27, 16,

and 17, respectively, for a total of 88. Thirteen observations were removed because the

firm refinanced or the CEO or directors were replaced leaving a sample of 75 firms

having overconfident managers.

Brown and Sarma (2007) find that the higher the CEO’s salary, relative to other

top managers, the stronger his place of dominance in the company’s hierarchy. Following

Hayward and Hambrick (1997), we use the CEO’s relative salary as a second measure of

managerial overconfidence. The higher the CEO’s salary, the more important his position

and the more overconfident he may be. The average salary of top 3 managers divided by

the average salary of all top managers is used as a proxy for the overconfidence of

managers, the higher the ratio, the more overconfident the manager. Table 2 presents

descriptive statistics of this data.

[Insert Table 2 Here]

7
Because of the severe punishment firms tend to be cautious when they forecast earnings.

11
5. Empirical Results

5.1 Descriptive statistics

Table 3 presents a summary of the descriptive statistics of firm expansion by

industry. Descriptions of internal investment and total investment are based on the entire

sample while M&A values are based on an M&A sub-sample of 436 firms. Twelve

Industries are identified (excluding financial firms) using the CSSC 2001 industrial

classification system. The table shows firm expansion across different industries. Average

internal investment ranges from 1.5% in real estate to 8.7% in mining. The mean and

median of internal investment are 5.5% and 3.6%, respectively while the mean and

median of total investment is 5.7% and 3.9%, respectively. The mean and median

expansion rates for M&As are 1.8% and 0.9%, respectively, suggesting that internal

investment is larger than M&A.

[Insert Table 3 Here]

Table 4 reports descriptive statistics for firm expansion across different years. The

table shows a great deal of variation among expansion rates over different periods.

[Insert Table 4 Here]

5.2. Regression results

5.2.1 Firm expansion and managerial overconfidence

Table 5 examines firm expansion and managerial overconfidence. Panel A uses

CON1 as the measure for managerial overconfidence. Following Lin et al. (2005), the

variable CON1 is equal to 1 if the firm’s forecasted earnings are greater than actual

earnings, 0 otherwise. The variable MA represents the value of M&A deals, defined as

the total value of all deals in each year divided by total assets at the end of the year. The

12
variable ININVEST captures net internal investment defined as cash spent purchasing

fixed and intangible assets less net cash received from selling fixed and intangible assets,

depreciation in the same year, divided by total assets at the end of the year. INVEST

captures the sum of the deal values both M&A and internal investment. The mean and

median M&A activity for firms with overconfident managers is smaller than for the

control group, but not statistically significant. However, the mean and median of firms

with overconfident managers is larger and statistically significant when examining both

total investment and internal investment. This indicates that the overall rate of expansion

rate and internal expansion rate of the firms with overconfident managers is faster than

for the control group.

Panel B of Table 5 establishes the robustness of this result by using a different

measure of managerial confidence. CON2 is the ratio of the average of top three

managers’ salaries divided by the average of all top managers salaries, the higher the

value, the more confident the manager. We divide this group in half with a cutoff point of

50%. If CON2 is greater than or equal to 50%, the firm’s manager is overconfident. If

less than 50% the firm’s management is not overconfident. We repeat the t test and

Wilcoxon test and find qualitatively similar results.

[Insert Table 5 Here]

Table 6 reports the regression results of the firm’s investment using CON1, the

first measure of managerial overconfidence. Multiple new dependent variables are

introduced including MADUM, a dummy variable capturing whether M&A activity

occurred and which is equal to 1 if it did, 0 otherwise. ININVEST and INVEST, defined

as cash spent in purchasing fixed assets, intangible assets, etc. less net cash received from selling

fixed assets, intangible assets, etc. less depreciation in the same year divided by total assets at the

13
end of the year and; INVEST, defined as the sum of M&A and internal investment, respectively.

Cash flow, CF, is defined as net cash flow at the beginning of the year divided by total

assets at the beginning of the year. CONTROL is a dummy variable capturing whether

the State is the major blockholder and takes a value of 1 if the major shareholder is the

state, 0 otherwise. DIRSIZE is defined as the number of members of the board of

directors. The percentage of independent directors, DDSIZE, is defined as the number of

independent directors divided by the total number of directors. Investment opportunity,

TOBINQ, is defined as value of negotiable stocks in the beginning of the year plus book

value of non-negotiable stock at the beginning of the year plus the book value of debt

divided by book value of total assets at the beginning of the year. The firm’s growth,

GROW, is defined as sales in the previous year less sales in the year prior to that divided

by total assets at the beginning of the year. The percentage of intangible assets, INTAN,

is defined as intangible assets at the beginning of the year divided by total assets at the

beginning of the year. A dummy variable which captures whether the parent company is

part of a group company (JT) where the value is 1 if the parent company is a group

company, 0 otherwise. The debt ratio of the firm, DEBT, is defined as total debt at the

beginning of the year divided by total assets at the beginning of the year. Firm size, SIZE,

is defined as the natural log of total assets at the beginning of the year. Industry, IND, is

categorized using 11 dummy variables according to the CSSC. Three dummy variables

capture the year (YEAR). Model 1, 3, and 4 are OLS regression models while Model 2 is

logit regression.

The results of regression Model 1 and 2 show that the coefficients of CON1 are

negative, but not significant. In Model 3 and Model 4, however, the coefficients of CON1

is positive and statistically significant at the 5% level. These results indicate that if the

14
firm’s manager is overconfident the firm has a more rapid overall expansion rate and its

internal expansion rate is also likely to be faster but that this is not the case for external

expansion. The external expansion rate for firms is slower. The finding that firms with

overconfident managers experience slower external expansion (M&A) seems inconsistent

with the existing literature (e.g., see Malmendier and Tate (2003)). However, this may be

due to the institutional background in China, which will be discussed at the end of this

section.

[Insert Table 6 Here]

In Table 7, CON2 replaces CON1 and is used in the same regression models. The

findings are qualitatively similar to those found in Table 6. That being, firms with

overconfident managers expand more rapidly. Therefore we fail to reject Hypothesis 1

that overconfident managers expand firms faster than less confident managers.

[Insert Table 7 Here]

Another result of interest from Tables 6 and 7 is the negative and significant

coefficient of CONTROL. CONTROL is a dummy variable equal to 1 if the controlling

shareholder is the state. The negative coefficient indicates that firms not controlled by the

state expand faster than state-controlled firms.

5.2.2 Internal expansion, M&A and managerial overconfidence

Table 6 and 7 suggest that overconfident managers prefer internal to external

expansion. To investigate this issue in greater detail the variable MABININVEST, a

dummy variable used to capture whether external investment is greater than internal

investment is introduced. MABININVEST is a dummy variable equal to 1 if M&A

expenditures are greater than internal investment, 0 otherwise. A second variable,

15
MAINVEST is used to establish robustness and is defined as the percentage of M&A

investment divided by total investment. The regression results are reported in Table 8.

Model 5 and 6 are logit regressions and Models 7 and 8 are Tobit regressions.

[Insert Table 8 Here]

In Table 8 the coefficients of managerial overconfidence are all negative, but not

statistically significant (except for Model 8 where it is significant at the 10% level). This

implies that when overconfident managers choose to expand their firms, not only do they

expand much faster than firms without overconfident managers, but also they tend to rely

more heavily on internal rather than external expansion. This result appears to be

inconsistent with the U.S. literature on the topic, where more confident managers are

more likely to expand through external measures (e.g., see Malmendier and Tate (2003),

Doukas and Petmezas, (2006), Brown and Sarma (2007)). However, we believe this

result is due to differences in the institutional backgrounds of China and the U.S. The

market in China is transitional and developing. Though its first stock exchange was

established in 1991, the capital market is still developing. Similarly, the M&A market is

also quite immature. Financial firms are unable to provide adequate financial resources

for acquirers. Second, many Chinese listed firms are state-owned-enterprises (SOE). That

is, the central or state governments control and are supervisors of the firm. The

involvement of the state likely hinders a firm’s operational activities, especially with

regards to acquisitions. Third, severe information asymmetry exists in China which may

prevent acquirers from buying targets. The lack of an effective corporate governance

system and external monitoring leads to opacity in Chinese firms and in some cases firms

may manipulate their financial reports to appear more profitable than they are. As a result,

16
legitimate reasons exist why managers may prefer internal to external expansion.

5.2.3 Causality between the managerial overconfidence and firm expansion

In the previous section, it was shown that firms with overconfident managers

expand more rapidly than firms without overconfident managers. In this section the

causality issue is addressed. It is possible that a firm’s more rapid expansion may cause

managerial overconfidence rather than the reverse. A simultaneous equations model is

used to examine the causal relationship between the firm’s expansion and managerial

overconfidence. The simultaneous equations are defined as follows:

INVEST=β0+β1CONi+β2CF+β3TOBINQ+β4CONTROL+β5DIRSIZE+β6DDSIZE+β7GR

OW+β8INTAN+β9JT+β10DEBT+β11SIZE+β12ΣINDi+β13ΣYEARi+ε (1)

CONi=γ0+γ1INVEST+γ2CONTROL+γ3DIRSIZE+γ4DDSIZE+γ5DEBT+γ6SIZE+γ7GEN

DER+γ8AGE+γ9ΣINDi+ +ε (2)

In Equation (1), the dependent variable is firm expansion, measured by INVEST.

The independent variables include CON1 and CON2 and other control variables. In

Equation (2) the dependent variable is managerial overconfidence, measured by CON1

and CON2. The independent variables include INVEST and other control variables.

Following Malmendier and Tate (2003) controls for the gender and age of managers are

used as independent variables, where gender is equal to 1 if the CEO is male, 0 otherwise

and age is the age of the CEO.

A 2SLS regression is run with the results are reported in Tables 9 and 10. The

17
variable CON1 is used to measure managerial overconfidence in Table 9 and CON2 is

used in Table 10. The results in the two tables are qualitatively similar. In Equation (1) of

Table 9, the coefficient of managerial overconfidence is positive and significant at the 1%

level. This is consistent with the previous results and suggests that managerial

overconfidence has a positive impact on firm expansion even after controlling for

causality between the firm’s expansion and managerial overconfidence. The coefficient of

CONTROL, whether the firm is controlled by the state, is positive and significant at the

1% level indicating that firms tend to expand more rapidly if the controlling shareholder

is not the state. Table 10 exhibits a similar pattern when CON2 is used to measure

managerial overconfidence and indicates robustness in the results.

Table 9 and 10 also show that the firm’s expansion has a positive impact on

managerial confidence. This is not surprising since the bigger the firm is, the more likely

the manager will be overconfident and is consistent with the literature.

[Insert Table 9 and 10]

5.2.4 Managerial overconfidence, firm expansion and performance

Firms with overconfident managers expand faster than firms without

overconfident managers. In this section, we examine “how” and “if” managerial

overconfidence affects firm performance. Return on assets (ROA) is used to measure firm

performance. 8 Table 11 reports the regression results of ROA on CON1 and other

variables. 9

[Insert Table 11]

8
The results are qualitatively similar using Return on Equity (ROE) but are not reported for the sake of
brevity.
9
Lang (2001) argues that in China stock returns can not accurately measure the firm performance as they
severely deviate from corporate fundamentals.

18
 Model 9 indicates that the coefficient of CON1 is significant and negative at 10%

level implying that managerial overconfidence has a negative impact on firm

performance. In Model 10, the interaction term CON1*INVEST, the product of

managerial overconfidence measure CON1 and total investment is added. While the

coefficient of CON1 is insignificant, the coefficient CON1*INVEST is negative and

significant at 1% level, implying that managerial overconfidence tends to have a negative

impact on firm performance because overconfident managers are likely to choose

overinvestment, consistent with Stulz (1990). When CON2 is used instead of CON1, we

obtain the similar results.

[Insert Table 12]

6. Conclusion

We believe this paper is the first to examine the relationship between firm

expansion and managerial overconfidence in China. Managerial overconfidence is found

to positively affect the firm’s expansion rate measured by both total investment and

internal expansion. This paper also finds that the correlation between M&A activity and

managerial overconfidence is negative though not significant. This we suggest is not

surprising considering the institutional background of China. A simultaneous equations

model is used to investigate the causality between firm expansion and managerial

overconfidence. The results indicate causality in both directions. Lastly, this paper

investigates the relationship between firm performance and managerial overconfidence

and finds that overconfident managers tend to overinvest, decreasing firm value. The

results are of interest as they not only enrich the existing body of literature but have

implications for industry.

19
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22
Table 1
Table 1 describes the how the population of the initial data set was reduced by the number of
firms which disclosed earnings forecasts, by firms which missed earnings, and, hence were not
considered overconfident, less firms which financed within one year to remove the possibility
of earnings management and firms where the directors or CEO were replaced. The data set
contains observations between 2002-2005.
2002 2003 2004 2005 Total
Total number of firms 895 895 895 895 895
Number of firms that disclose earnings forecast 423 495 475 561 1954
Number of firms whose earnings are lower than
28 27 16 17 88
forecast at least once
Less: firms that finance within one year after they
3 0 2 2 7
disclose earnings forecast
Firms whose directors or CEOs were replaced 2 0 1 3 6
Remaining observations 23 27 13 12 75

Table 2
Descriptive statistics of managerial overconfidence measured by managers’
relative salaries. Managerial overconfidence is defined as the ratio of the
average of the top 3 managers’ salaries divided by the average of all top
managers’ salaries is used as an indication of managerial overconfidence. The
data set contains observations from 2002-2005.
2002 2003 2004 2005 Total
Mean 6.5 6.8 7.0 7.2 6.9
Median 6.1 6.5 6.8 6.9 6.6
Maximum 17.2 15.7 18.4 19.0 19.0
Minimum 1.4 0.8 1.3 0.4 0.4
Standard Dev 2.4 2.4 2.5 2.4 2.4
Observations 782 794 840 844 3,260

23
Table 3
Descriptive statistics of firms’ expansion across different industries. The industry types are classified
according to the Chinese Security Supervision Committee (CSSC) system. The data is divided into 11
industries. Internal investment is defined as cash spent in purchasing fixed assets, intangible assets, etc.
less net cash received in selling fixed assets, intangible assets, etc. less depreciation in the same year
divided by total assets at the end of the year. Total investment is defined as the sum of M&A expenditure
and internal investment. The data set contains observations from 2002-2005.
Whole sample M&A sub-sample
Internal investment
Industry Total investment (%) Deal Value (%)
Obs. (%) Obs.
Mean Median S.D. Mean Median S.D. Mean Median S.D.
Agriculture
and Forestry
63 5.5 4.7 4.6 5.8 4.9 4.6 11 1.7 1.0 2.2
Mining 42 8.7 7.3 6.5 8.8 7.5 6.5 3 0.7 1.0 0.6
Manufacturing 1,900 6.0 4.2 6.1 6.2 4.5 6.1 199 1.6 0.7 2.1
Production and
Distribution of
Electric
Power, Coal,
136 8.6 6.9 7.4 8.9 7.0 7.4 16 1.9 1.2 2.3
Gas, and
Water
Construction 53 4.2 2.7 4.7 4.5 2.9 4.9 7 2.8 3.1 1.7
Transportation
and Storage
115 8.4 5.1 9.1 8.8 5.3 9.1 14 2.5 1.9 2.5
Commerce 193 3.0 1.8 3.7 3.2 2.1 3.9 29 2.1 0.6 2.8
Information
Technology
284 4.1 2.5 4.7 4.5 2.9 4.8 60 1.9 1.1 2.3
Real Estate 133 1.5 0.3 2.6 1.8 0.4 3.0 25 1.6 0.5 2.2
Social
Services
109 7.3 5.7 6.4 7.6 5.8 6.4 23 1.7 0.9 2.0
Media 26 4.7 2.4 5.4 5.4 3.6 6.3 4 4.5 4.0 2.5
Misc 269 3.6 1.9 4.6 3.9 2.1 4.7 45 1.8 0.8 2.3
Total 3,323 5.5 3.6 6.0 5.7 3.9 6.1 436 1.8 0.9 2.2

Table 4
Descriptive statistics for firm expansion across time. The data set contains observations from 2002-
2005. Internal investment is defined as cash spent in purchasing fixed assets, intangible assets, etc.
less net cash received in selling fixed assets, intangible assets and etc. less depreciation in the same
year divided by total assets in the end of the year. Total investment is defined as the sum of M&A
expenditures and internal investment.
Whole sample M&A sub-sample
Internal Investment（%） Total Investment（%） Deal Value（%）
Year Obs. Mean Median S.D. Mean Median S.D. Obs. Mean Median S.D.
2002 848 5.7 3.7 6.0 6.1 4.1 6.1 142 2.0 1.0 2.5
2003 840 5.8 3.9 6.0 6.0 4.2 6.1 105 2.0 1.1 2.1
2004 825 5.6 3.6 6.2 5.7 3.8 6.2 64 1.8 1.0 2.3
2005 810 5.0 3.1 5.8 5.2 3.5 5.8 125 1.3 0.6 1.8
Total 3,323 5.5 3.6 6.0 5.7 3.9 6.1 436 1.8 0.9 2.2

24
Table 5
Univariate results examining two different confidence measures, CON1, a
dummy variable equal to 1, if the forecasted earnings are greater than the actual
earnings, 0 otherwise and; CON2, defined as the sum of top three managers’
salaries divided by sum of all top managers’ salaries. Three variables, MA,
defined as total deal value in each year divided by total assets at the end of the
year; ININVEST defined as cash spent in purchasing fixed assets, intangible
assets and etc less net cash received in selling fixed assets, intangible assets and
etc less depreciation in the same year divided by total assets in the end of the
year and; INVEST, defined as the sum of M&A and internal investment. The
data set contains observations from 2002-2005. Statistical significance is tested
using the t-test and the Wilcoxon test.
Panel A
CON1 Obs. Mean Median t-test Wilcoxon test
1 32 1.5 0.6
MA -0.88 -0.37
0 404 1.8 0.9
1 212 6.9 4.6
ININVEST 2.25** -2.52**
0 2,278 5.7 3.7
1 218 7.0 4.8
INVEST 1.95* -2.07**
0 2,313 5.9 4.0

Panel B
CON2 Obs. Mean Median t-test Wilcoxon test
1 201 1.8 0.0
MA
0 235 1.7 0.0
1 1,285 6.3 3.8
ININVEST -2.04** -1.97**
0 1,246 5.8 3.6
1 1,285 6.1 4.1
INVEST -1.99** -1.74*
0 1,246 5.6 3.9
*, **, and *** indicate statistical significance at the 10%, 5%, and 1% levels, respectively.

25
 Table 6
Regression results examine firm expansion on CON1. CON1 is a dummy variable equal to 1 if
forecast earnings are greater than actual earnings, 0 otherwise. The dependent variables are
MA, MADUM, ININVEST and INVEST. MA is defined as total deal value in each year
divided by total assets at the end of the year; MADUM is a dummy variable which captures
whether there was any M&A activity and is equal to 1 if there was, 0 otherwise; ININVEST is
defined as cash spent in purchasing fixed assets, intangible assets, etc. less net cash received
from selling fixed assets, intangible assets, etc. less depreciation in the same year divided by
total assets at the end of the year; INVEST is defined as the sum of M&A and internal
investment. CF is defined as net cash flow from the previous period divided by total assets at
the beginning of the year. CONTROL is a dummy variable equal to 1 if the largest blockholder
is the state, 0, otherwise; DIRSIZE is defined as the number of board members; DDSIZE is
defined as the number of independent directors divided by the total number of directors;
TOBINQ is defined as the (value of negotiable stocks in the beginning of the year plus book
value of nonnegotiable stocks in the beginning of the year plus book value of debt) divided by
book value of total assets at the beginning of the year; GROW is defined as (sales in the last
year less sales in the year before last year) divided by total assets in the beginning of the year;
INTAN is defined as intangible assets at the beginning of the year divided by total assets at the
beginning of the year; JT is a dummy variable equal to 1, if parent company is group
company; 0, otherwise; DEBT is defined as total debt at the beginning of the year divided by
total assets at the beginning of the year; SIZE is defined as the natural logarithm of total assets
at the beginning of the year; IND is an 11 industry dummy variable classified according to the
Chinese Security Supervision Committee (CSSC) industry code classifications; YEAR is a
dummy variable capturing whether the year is 2002, 2003, 2004, or 2005.

Model 1 Model 2 Model 3 Model 4

(Depend.: MA) (Depend.: MADUM) (Depend.: ININVEST) (Depend.: INVEST)
Coeff. t-statistic Coeff. Wald Coeff. t-statistic Coeff. t-statistic
Intercept -0.27 -0.58 -8.86 35.61*** 2.92 0.76 2.75 0.72
CON1 -0.05 -0.83 -0.17 0.67 1.11 2.34** 0.94 2.00**
CF 0.26 1.612* 1.07 0.08 1.34 1.07 1.74 1.39
CONTROL -0.15 -3.74*** -0.59 -24.68*** -0.93 -2.93*** -1.06 -3.34***
DIRSIZE 0.00 0.02 -0.01 0.10 0.09 1.48 0.09 1.37
DDSIZE 0.01 0.02 0.56 0.45 3.36 1.606* 3.13 1.50
TOBINQ -0.02 -0.48 0.06 0.20 0.42 1.17 0.41 1.15
GROW 0.00 1.53 0.00 0.77 -0.03 -1.04 -0.01 -0.90
INTAN -0.14 -0.51 1.06 1.60 6.00 2.70*** 5.68 2.57***
JT 0.00 -0.01 -0.27 4.72** 0.21 0.63 0.23 0.71
DEBT -0.01 -0.27 -0.01 0.01 0.54 1.27 0.54 1.29
SIZE 0.03 1.52 0.36 29.01*** -0.02 -0.13 0.01 0.08
IND Controlled Controlled Controlled Controlled
YEAR Controlled Controlled Controlled Controlled
Adj-R2 0.01 0.04 0.05 0.05
*, **, and *** indicate statistical significance at the 10%, 5%, and 1% levels, respectively.

26
Table 7
Regression results examine firm expansion on CON2, where CON2 is defined as the sum of top
three managers’ salaries divided by sum of all top managers’ salaries. The dependent variables are
MA, MADUM, ININVEST and INVEST. MA is defined as total deal value in each year divided
by total assets at the end of the year; MADUM is a dummy variable which captures whether there
was any M&A activity and is equal to 1 if there was, 0 otherwise; ININVEST is defined as cash
spent in purchasing fixed assets, intangible assets, etc. less net cash received from selling fixed
assets, intangible assets, etc. less depreciation in the same year divided by total assets at the end of
the year; INVEST is defined as the sum of M&A and internal investment. CF is defined as net
cash flow from the previous period divided by total assets at the beginning of the year.
CONTROL is a dummy variable equal to 1 if the largest blockholder is the state, 0, otherwise;
DIRSIZE is defined as the number of board members; DDSIZE is defined as the number of
independent directors divided by the total number of directors; TOBINQ is defined as the (value
of negotiable stocks in the beginning of the year plus book value of nonnegotiable stocks in the
beginning of the year plus book value of debt) divided by book value of total assets at the
beginning of the year; GROW is defined as (sales in the last year less sales in the year before last
year) divided by total assets in the beginning of the year; INTAN is defined as intangible assets at
the beginning of the year divided by total assets at the beginning of the year; JT is a dummy
variable equal to 1, if parent company is group company; 0, otherwise; DEBT is defined as total
debt at the beginning of the year divided by total assets at the beginning of the year; SIZE is
defined as the natural logarithm of total assets at the beginning of the year; IND is an 11 industry
dummy variable classified according to the Chinese Security Supervision Committee (CSSC)
industry code classifications; YEAR is a dummy variable capturing whether the year is 2002,
2003, 2004, or 2005.

Model 1 Model 2 Model 3 Model 4

(Depend.: MA) (Depend.: MADUM) (Depend.: ININVEST) (Depend.: INVEST)
Coeff. t-statistic Coeff. Wald Coeff. t-statistic Coeff. t-statistic
Intercept -0.28 -0.56 -8.35 -5.27*** 2.56 0.65 2.60 0.67
CON2 -0.01 -1.16 -0.06 -2.24** 0.17 3.02*** 0.16 2.85***
CF 0.28 1.50 0.97 1.45 1.01 0.70 1.52 1.05

CONTROL -0.26 -1.85* -0.10 -1.74* -0.41 -3.59*** -0.63 -3.72***

DIRSIZE 0.00 0.10 0.00 0.09 -0.01 -0.20 -0.02 -0.34
DDSIZE 0.05 0.17 1.07 1.22 3.53 1.70* 3.22 1.56
TOBINQ 0.03 0.49 0.12 0.73 0.57 1.37 0.59 1.43
GROW 0.00 1.79* 0.01 1.16 -0.03 -1.22 -0.01 -0.83
INTAN -0.03 -0.09 1.30 1.47 6.74 2.97*** 6.58 2.92***
JT -0.02 -0.51 -0.29 -2.24** 0.04 0.12 0.04 0.14
DEBT -0.02 -0.26 -0.11 -0.45 -0.57 -1.00 -0.56 -0.99
SIZE 0.03 1.64* 0.34 4.85*** 0.02 0.14 0.05 0.31
IND Controlled Controlled Controlled Controlled
YEAR Controlled Controlled Controlled Controlled
Adj-R2 0.01 0.04 0.05 0.04
*, **, and *** indicate statistical significance at the 10%, 5%, and 1% levels, respectively.

27
 Table 8
Managerial overconfidence and the choice of internal or external expansion. The dependent
variables are MABININVEST a dummy variable equal to 1, if MA is more than internal
investment 0, otherwise and MAINVEST, defined as M&A expenditures divided by total
investment. CON1 is a dummy variable defined as equal to 1, if forecasted earnings are
greater than actual earnings, 0, otherwise; CON2 is defined as the sum of the top three
managers’ salaries divided by the sum of all top managers’ salaries; CF is defined as net
cash flow in the previous period divided by total assets at the beginning of the year;
CONTROL is a dummy variable equal to 1 if the largest shareholder is the state, 0,
otherwise; DIRSIZE is defined as the number of board members; DDSIZE is defined as the
number of independent directors divided by the total number of directors; TOBINQ is
defined as the (value of negotiable stocks in the beginning of the year plus book value of
nonnegotiable stocks at the beginning of the year plus book value of debt) divided by book
value of total assets at the beginning of the year; GROW is defined as (sales in the previous
year less sales in the year before the previous year) divided by total assets at the beginning
of the year; INTAN measures intangible assets and is defined as intangible assets at the
beginning of the year divided by total assets at the beginning of the year; JT is a dummy
variable equal to 1, if the parent company is group company; 0, otherwise; DEBT is
defined as total debt at the beginning of the year divided by total assets at the beginning of
the year; SIZE is defined as the natural logarithm of total assets at the beginning of the
year; IND is an 11 industry dummy variable classified according to the Chinese Security
Supervision Committee (CSSC) industry code classifications; YEAR is a dummy variable
capturing whether the year is 2002, 2003, 2004, or 2005.

Dependent: MABININVEST Dependent: MAINVEST

Model 5 Model 6 Model 7 Model 8
Coeff. Wald Coeff. Wald Coeff. t-stat Coeff. t-stat
Intercept 11.47 98.60*** 11.00 8.86*** 0.16 1.08 0.14 0.89
CON1 -0.021 0.024 -0.001 -0.02
CON2 -0.004 -0.24 -0.004 -1.69*
CF -0.164 0.188 -0.611 -1.37 0.029 0.6 0.034 0.60
CONTROL -0.112 -1.637 -0.018 -0.96 -0.039 -3.3*** -0.321 -1.49
DIRSIZE 0.004 0.051 0.001 0.02 0.001 0.39 0.002 0.85
DDSIZE -1.48 5.98** -1.21 -1.90* -0.024 -0.3 0.020 0.25
TOBINQ -0.403 15.84*** -0.44 -3.52*** -0.025 -1.84* -0.018 -1.09
GROW 0.002 0.19 0.001 0.13 0.002 3.49*** 0.002 3.62***
INTAN -1.383 4.26** -1.375 -1.91* -0.102 -1.22 -0.070 -0.79
JT 0.196 4.38*** 0.228 2.31** 0.007 0.53 0.004 0.30
DEBT 0.356 10.31*** 0.604 3.89*** 0.011 0.68 0.021 0.93
SIZE -0.571 12.70*** -0.56 -10.37*** -0.003 -0.43 -0.003 -0.40
IND Controlled Controlled Controlled Controlled
YEAR Controlled Controlled Controlled Controlled
R2 0.06 0.05 0.454 0.803
*, **, and *** indicate statistical significance at the 10%, 5%, and 1% levels, respectively.

28
 Table 9
Regression results of simultaneous equations Model 1 and Model 2:
INVEST=β0+β1CON1+β2CF+β3TOBINQ+β4CONTROL+β5DIRSIZE+β6DDSIZE+β7GROW+
β8 INTAN+β9JT+β10DEBT+β11SIZE+β12ΣINDi+β13ΣYEARi+ε (1)
CON1=γ0+γ1INVEST+γ2CONTROL+γ3DIRSIZE+γ4DDSIZE+γ5DEBT+γ6SIZE+γ7GENDER+
γ8AGE+γ9ΣINDi+ +ε (2)
where, CON1 is a dummy variable defined as equal to 1, if forecasted earnings are greater
than actual earnings, 0, otherwise; CF is defined as net cash flow from the previous period
divided by total assets in the beginning of the year; TOBINQ is defined as the (value of
negotiable stocks in the beginning of the year plus book value of nonnegotiable stocks at the
beginning of the year plus book value of debt) divided by book value of total assets at the
beginning of the year; CONTROL is a dummy variable equal to 1 if the largest shareholder is
the state, 0, otherwise; DIRSIZE is defined as the number of board members; DDSIZE is
defined as the number of independent directors divided by the total number of directors;
GROW is defined as (sales in the previous year less sales in the year before the previous year)
divided by total assets at the beginning of the year; INTAN measures intangible assets and is
defined as intangible assets at the beginning of the year divided by total assets at the beginning
of the year; JT is a dummy variable equal to 1, if the parent company is group company; 0,
otherwise; DEBT is defined as total debt at the beginning of the year divided by total assets at
the beginning of the year; GENDER is a dummy variable which takes the value of 1 if the
CEO is a man, 0 otherwise; IND is an 11 industry dummy variable classified according to the
Chinese Security Supervision Committee (CSSC) industry code classifications; YEAR is a
dummy variable capturing whether the year is 2002, 2003, 2004, or 2005.
Equation (1) Equation (2)
Coefficient Z-score Coefficient Z-score
Intercept 8.80 1.73* -0.73 -3.60***
CON1 2.50 4.35***
INVEST 0.005 4.48***
CF 1.58 0.91
TOBINQ 0.213 0.44
CONTROL -1.11 -2.70*** 0.065 3.46***
DIRSIZE 0.045 0.55 0.005 1.33
DDSIZE 1.72 0.66 0.144 1.21
GROW -0.011 -0.83
INTAN 8.47 3.13***
JT 0.222 0.52
DEBT -0.751 -1.10 0.021 0.69
SIZE -0.168 -0.76 0.031 3.39***
GENDER 0.043 1.14
AGE -0.001 -1.36
ΣINDi Controlled Controlled
ΣYEARi Controlled Controlled
R2 0.07 0.05
*, **, and *** indicate statistical significance at the 10%, 5%, and 1% levels, respectively.

29
 Table 10
Regression results of simultaneous equations Model 1 and Model 2:
INVEST=β0+β1CON2+β2CF+β3TOBINQ+β4CONTROL+β5DIRSIZE+β6DDSIZE+β7GROW+
β8 INTAN+β9JT+β10DEBT+β11SIZE+β12ΣINDi+β13ΣYEARi+ε (1)
CON2=γ0+γ1INVEST+γ2CONTROL+γ3DIRSIZE+γ4DDSIZE+γ5DEBT+γ6SIZE+
γ7GENDER+γ8AGE+γ9ΣINDi+ +ε (2)
where, CON2 is defined as the sum of top three managers’ salaries divided by sum of all top
managers’ salaries; CF is defined as net cash flow from the previous period divided by total
assets in the beginning of the year; TOBINQ is defined as the (value of negotiable stocks in
the beginning of the year plus book value of nonnegotiable stocks at the beginning of the year
plus book value of debt) divided by book value of total assets at the beginning of the year;
CONTROL is a dummy variable equal to 1 if the largest shareholder is the state, 0, otherwise;
DIRSIZE is defined as the number of board members; DDSIZE is defined as the number of
independent directors divided by the total number of directors; GROW is defined as (sales in
the previous year less sales in the year before the previous year) divided by total assets at the
beginning of the year; INTAN measures intangible assets and is defined as intangible assets at
the beginning of the year divided by total assets at the beginning of the year; JT is a dummy
variable equal to 1, if the parent company is group company; 0, otherwise; DEBT is defined
as total debt at the beginning of the year divided by total assets at the beginning of the year;
GENDER is a dummy variable which takes the value of 1 if the CEO is a man, 0 otherwise;
IND is an 11 industry dummy variable classified according to the Chinese Security
Supervision Committee (CSSC) industry code classifications; YEAR is a dummy variable
capturing whether the year is 2002, 2003, 2004, or 2005.
Equation (1) Equation (2)
Coefficient Z-score Coefficient Z-score
Intercept 6.892 1.34 3.279 1.99**
CON2 0.394 5.25***
INVEST 0.053 5.27***
CF 0.703 0.40
TOBINQ 0.219 0.44
CONTROL -1.066 -2.59*** 0.339 2.26**
DIRSIZE -0.117 -1.34 0.407 13.60***
DDSIZE 1.954 0.74 1.972 2.06**
GROW -0.012 -0.87
INTAN 9.006 3.24***
JT 0.207 0.49
DEBT -0.972 -1.44 0.371 1.54
SIZE -0.107 -0.48 -0.091 -1.25
GENDER 0.203 0.67
AGE -0.010 -1.30
ΣINDi Controlled Controlled
ΣYEARi Controlled Controlled
R2 0.07 0.04
*, **, and *** indicate statistical significance at the 10%, 5%, and 1% levels, respectively.

30
Table 11
Table 11 shows the regression results where the dependent variable is Return on Assets
(ROA), defined as net income divided by total assets. CON1 is a dummy variable defined as
equal to 1, if forecasted earnings are greater than actual earnings, 0, otherwise;
CON1*INVEST is an interaction term equal to the product of CON1 and INVEST;
CONTROL is a dummy variable equal to 1 if the largest shareholder is the state, 0,
otherwise; DIRSIZE is defined as the number of board members; DEBT is defined as total
debt at the beginning of the year divided by total assets at the beginning of the year; SIZE is
defined as the natural logarithm of total assets at the beginning of the year; IND is an 11
industry dummy variable classified according to the Chinese Security Supervision
Committee (CSSC) industry code classifications; YEAR is a dummy variable capturing
whether the year is 2002, 2003, 2004, or 2005.

Model 9 Model 10
Coeff. t-statistic Coeff. t-statistic
Intercept -0.004 -0.00 0.934 0.55
CON1 -2.233 -1.81* -0.002 -0.02
CON1*INVEST -0.038 -3.52***
CONTROL 0.025 0.31 0.058 1.00
DIRSIZE -0.019 -1.20 -0.002 -0.19
DEBT 0.354 2.87*** 0.415 4.09***
SIZE -0.028 -0.90 -0.047 -1.68*
ΣINDi Controlled Controlled
ΣYEARi Controlled Controlled
R2 0.01 0.02
*, **, and *** indicate statistical significance at the 10%, 5%, and 1% levels, respectively

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 Table 12
Table 12 shows the regression results where the dependent variable is Return on Assets
(ROA), defined as net income divided by total assets. CON2 is defined as the sum of top
three managers’ salaries divided by sum of all top managers’ salaries; CON2*INVEST is
an interaction term equal to the product of CON2 and INVEST; CONTROL is a dummy
variable equal to 1 if the largest shareholder is the state, 0, otherwise; DIRSIZE is defined
as the number of board members; DEBT is defined as total debt at the beginning of the year
divided by total assets at the beginning of the year; SIZE is defined as the natural logarithm
of total assets at the beginning of the year; IND is an 11 industry dummy variable classified
according to the Chinese Security Supervision Committee (CSSC) industry code
classifications; YEAR is a dummy variable capturing whether the year is 2002, 2003, 2004,
or 2005.
Model 9 Model 10
Coeff. t-statistic Coeff. t-statistic
Intercept 0.128 0.14 1.177 1.80*
CON2 -0.004 -0.26 0.001 0.72
CON2*INVEST -0.002 -3.32***
CONTROL 0.025 0.28 0.053 0.85
DIRSIZE -0.022 -1.71* -0.004 -0.35
DEBT 0.353 2.66*** 0.422 3.90***
SIZE -0.008 -0.20 -0.057 -1.88*
ΣINDi Controlled Controlled
ΣYEARi Controlled Controlled
R2 0.01 0.01
*, **, and *** indicate statistical significance at the 10%, 5%, and 1% levels, respectively

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