Abstract
We experimentally investigate the role of deniability and communication in reducing managerial overinvestment. Managers often have private information about the profitability of a particular investment, and capital markets may assume that the investment itself indicates that the manager's information was favorable. In this case, managers who value the share price of their firm have an incentive to overinvest, i.e. to make an investment even when the net present value of the investment is negative. In our experiment, managers make investment decisions and traders can buy or sell shares of the firm. Overinvestment is the unique equilibrium of the one-shot game, but in a repeated setting it can also be an equilibrium to make efficient investment choices. We experimentally vary whether managers can communicate their investment plans to traders, and whether managers can credibly deny that an inefficient investment was due to bad luck rather than a deliberate misrepresentation of the manager's intentions. We hypothesize that the introduction of communication will reduce overinvestment by managers, and the effect will be stronger when lies are detectable as opposed to the treatments where lies are deniable.