Investment Timing, Agency and Information

Abstract

This paper provides a model of optimal investment timing in a decentralized firm under conditions of agency and asymmetric information. Using a real options approach, we show that an underlying option to invest can be decomposed into two components: a manager's option and an owner's option. The terms of the manager's option are determined by an optimal contracting model, and provide an incentive for the manager to both extend effort and truthfully reveal his private information. The implied investment behavior differs significantly from that of standard real options models. 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, capital budgeting, agency cost, hidden information, hidden action, investment timing

JEL Classification: G31