Abstract：In this paper, the behavior bias of the management such as loss aversion and overconfidence are considered in the principalagent model, and we find out that traditional RI based on the firm’s cost of capital will induce underinvestment if a manager displays lossaversion, and will induce overinvestment if a manager is optimistic. Our model illustrates that in order to eliminate the underinvestment and overinvestment and achieve the goalcongruence between the shareholder and the manager, the incentive compatible cost of capital should be set to be lower than its true value for the lossaverse manager; while for the optimistic manager, the incentive compatible cost of capital should be higher than its true value. This conclusion improves the traditional theory about the residual income.
2012, Vol. 9 
