Costly Learning and Agency Conflicts in Investments Under Uncertainty
54 Pages Posted: 16 Mar 2012 Last revised: 21 May 2013
Date Written: April 1, 2013
This paper studies endogenous learning and investment timing of managers in decentralized firms. While the "option to wait" in traditional real options models only concerns future uncertainties, another important source of managerial flexibility is the resolution of past uncertainties through costly effort, which mitigates investment inefficiencies caused by incomplete information. In equilibrium, timing of learning is crucial, and optimal strategies generally involve sequential thresholds for learning and investing. Moreover, costly learning naturally leads to information asymmetry between managers and outside investors, and managerial contracts are needed to incentivize learning and truthful reporting. The inherent agency conflicts distort investment behavior significantly, accelerating learning and high value projects while delaying low value projects. The distortions are costly to the investors and social welfare, and are sensitive to contractibility and cost of learning, as well as other fundamental characteristics of the market. In particular, with low market volatility or sufficient pledgeable liquidity for managers, contracting on learning restores investment efficiency. Among other implications, the model predicts that based on observed investment costs alone, projects appear delayed in general.
Keywords: Real options, Learning, Contracting, Asymmetric information, Agency
JEL Classification: D81, D82, D83, G13
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