Incentives and Investment Timing: Real Options in a Principal-Agent Setting

Abstract

In the standard real options approach to investment, the owner of the decides when to exercise the investment option. However, in many real-world settings, investment decisions are delegated to managers. This article provides a model of optimal contracting in a continuous-time principal-agent setting in which there is both moral hazard and adverse selection. We show that the underlying can be decomposed into two components: A manager's and an owner's option. The specification of the manager's is determined by a compensation contract, and must provide an incentive for the manager to both extend effort and to exercise as close to the value-maximizing stopping time as possible. The residual payout goes to the owner. The implied investment behavior differs significantly from that of the first-best no-agency solution. In particular, there will be greater inertia in investment, in that the model leads to the manager having an even greater option to wait than the owner. The interplay between the twin forces of hidden information and hidden action leads to markedly different investment outcomes than when only one of the two forces is at work.