Optimal Timing of Management Turnover in Agency Conflicts

Abstract

We explore the timing of the replacement of a manager as an important incentive mechanism, using a real options approach in a situation where the timing of the decision to replace the manager is related to a major change in a firm's strategies that involves spending large amounts of various sunk adjustment costs. In particular, we study this problem not only in a growing firm, but also in a declining firm under a continuous-time agency setting. We show that when renegotiation is not possible, the early replacement of the manager of a lower quality project (prior to the first-best trigger level) occurs only if a moral hazard problem exists. In addition, we indicate that the possibility of renegotiation drastically changes the results. The comparative static results with respect to the volatility of the business environment, the strength of the firm's governance and the competitiveness of the managerial labor market provide several empirical predictions related to executive compensation and turnover.