ever, unlike overconfident managers, optimistic managers will sometimes undertake projects that actually have negative expected net present values. This error may be mitigated by raising hurdle rates While compensation contracts that increase the convexity of manager payoffs can be used to realign the decisions of a rational manager with those of shareholders, it may be less expensive to simply hire an overconfident, optimistic manager. The gains from overconfidence and optimism will at times be sufficient that shareholders actually prefer an overconfident, optimistic manager with less ability to a rational manager with greater ability. Extreme overconfidence or optimism is, however, always detrimental to the firm. Extremely overconfident or optimistic managers will perceive too little risk or too little chance of failure. They will greatly underestimate of delaying a project or greatly overestimate the likelihood of success. When such individuals in charge of a firm's capital budgeting decisions, they will destroy that firm's value in the long run Our research helps to explain a puzzle in corporate finance. If rational individuals make better decisions than those influenced by behavioral biases, such as overconfidence, why are many CEO verconfident(Audia, Locke and Smith, 2000; Malmendier and Tate, 2001)? This puzzle can be viewed from the perspective of the individual manager and that of the firm. Gervais and Odean(2001)demonstrate, in the context of investors, that the human tendency to take too much credit for success and attribute too little credit to chance can cause successful people to become erconfident. Thus, in a corporate setting, managers who successfully climb the corporate ladder to become CEOs are likely to also become overconfident. In the current paper, we address the puzzle of CEO overconfidence from the perspective of the firm. We show that it can be in the best interest of shareholders to hire managers(e. g, CEOs) who are overconfident Our paper proceeds as follows. Section 2 reviews some of the literature on optimism and verconfidence. Section 3 introduces a simple capital budgeting problem that is used throughout the paper to analyze the effects of behavioral biases on the value of the firm. The same section presents the first-best solution, which serves as a benchmark for later sections. Section 4 formally introduces the concepts of overconfidence and optimism, and shows how these individual traits can ffect the value of the firm when a manager's sole intention is to maximize firm value. The principal agent nature of the relationship between firm owners and managers is analyzed in section 5. This section shows how contracting interacts with manager biases to solve the firms agency problems section 6. we show how our basic model can be extended to accommodate other forces that areever, unlike overconfident managers, optimistic managers will sometimes undertake projects that actually have negative expected net present values. This error may be mitigated by raising hurdle rates. While compensation contracts that increase the convexity of manager payoffs can be used to realign the decisions of a rational manager with those of shareholders, it may be less expensive to simply hire an overconfident, optimistic manager. The gains from overconfidence and optimism will at times be sufficient that shareholders actually prefer an overconfident, optimistic manager with less ability to a rational manager with greater ability. Extreme overconfidence or optimism is, however, always detrimental to the firm. Extremely overconfident or optimistic managers will perceive too little risk or too little chance of failure. They will greatly underestimate the option value of delaying a project or greatly overestimate the likelihood of success. When such individuals are put in charge of a firm’s capital budgeting decisions, they will destroy that firm’s value in the long run. Our research helps to explain a puzzle in corporate finance. If rational individuals make better decisions than those influenced by behavioral biases, such as overconfidence, why are many CEOs overconfident (Audia, Locke and Smith, 2000; Malmendier and Tate, 2001)? This puzzle can be viewed from the perspective of the individual manager and that of the firm. Gervais and Odean (2001) demonstrate, in the context of investors, that the human tendency to take too much credit for success and attribute too little credit to chance can cause successful people to become overconfident. Thus, in a corporate setting, managers who successfully climb the corporate ladder to become CEOs are likely to also become overconfident. In the current paper, we address the puzzle of CEO overconfidence from the perspective of the firm. We show that it can be in the best interest of shareholders to hire managers (e.g., CEOs) who are overconfident. Our paper proceeds as follows. Section 2 reviews some of the literature on optimism and overconfidence. Section 3 introduces a simple capital budgeting problem that is used throughout the paper to analyze the effects of behavioral biases on the value of the firm. The same section presents the first-best solution, which serves as a benchmark for later sections. Section 4 formally introduces the concepts of overconfidence and optimism, and shows how these individual traits can affect the value of the firm when a manager’s sole intention is to maximize firm value. The principal￾agent nature of the relationship between firm owners and managers is analyzed in section 5. This section shows how contracting interacts with manager biases to solve the firm’s agency problems. In section 6, we show how our basic model can be extended to accommodate other forces that are 2