Agency Contracts, Noncommitment Timing Strategies, and Real Options

Abstract:     
Given an owner's noncommitment timing strategy and a manager's hidden action, we consider how the corresponding timing decisions to launch a project and to replace the manager and change a project are determined and how the optimal compensation contract for the manager is designed. Using a real options approach, we show that, compared with the case of the owner's commitment timing strategy and the manager's hidden action, a higher (lower)-quality project is launched later (at the same time as the first-best case), whereas the replacement of the manager and change of the project is (is not necessarily) made later if the hidden-action problem is severe enough (is not severe enough). Unlike the folklore result of the standard moral hazard model, severance pay may serve to minimize the compensation for the manager's loss of his option value caused by loss of corporate control by committing the owner to delaying replacement of the manager if the hidden-action problem is not too severe.

Number of Pages in PDF File: 43

Keywords: agency, CEO turnover, executive compensation, noncommitment, real options, severance pay

JEL Classification: D82, G30, G34, M51, M52

working papers series