Are real options more valuable in the presence of agency conflicts?

Abstract

The theory on real options has extended the traditional net present value rule in order to capture the value of flexibility in investment decisions. Typically, the theory of real options does not take into account agency conflicts (between central and divisional management). In this paper, we investigate the influence of agency conflicts on real options within a LEN-type model. We extend a standard LEN model with investment activities by explicitly considering the possibility to abandon an investment project after all parties involved have received further information about the project’s development. Especially, we analyze how the option’s flexibility value is influenced by the agency conflict. Our analysis shows that the real option alters the trade-off between risk sharing and incentives that underlies the agency conflict. Thereby, situations can occur in which central (and divisional) management evaluates the abandonment option ex ante differently than ex post. Using this framework, we discuss the role of commitment and the advantages of centralization and delegation of the abandonment decision.