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

47 Pages Posted: 23 Apr 2003

See all articles by Steven R. Grenadier

Steven R. Grenadier

Stanford Graduate School of Business

Neng Wang

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Date Written: April 2003

Abstract

In the standard real options approach to investment, the owner of the option 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 option can be decomposed into two components: A manager's option and an owner's option. The specification of the manager's option 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 option 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.

Keywords: Real Options, Agency Costs, Hidden Information, Hidden Action, Investment Timing

JEL Classification: G31

Suggested Citation

Grenadier, Steven R. and Wang, Neng, Incentives and Investment Timing: Real Options in a Principal-Agent Setting (April 2003). Available at SSRN: https://ssrn.com/abstract=397680 or http://dx.doi.org/10.2139/ssrn.397680

Steven R. Grenadier (Contact Author)

Stanford Graduate School of Business ( email )

Graduate School of Business
Stanford, CA 94305-5015
United States
650-725-0706 (Phone)
650-725-6152 (Fax)

Neng Wang

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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