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Incentive Problems and Investment Timing Options

Author

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  • Antle, Rick
  • Bogetoft, Peter
  • Stark, Andrew W.

Abstract

We characterize optimal investment and compensation strategies in a model of an investment opportunity with managerial incentive problems, caused by asymmetric information over investment costs and the manager's desire to consume slack, and flexibility over the timing of its acceptance. The flexibility over timing consists of the opportunity to invest immediately, delay investment for one period, or not invest at all. The timing option provides an opportunity to invest when circumstances are most favorable. However, the timing option also gives the manager an incentive to influence the timing of the investment to circumstances in which he gets more slack. Under the assumption that investment costs are distributed independently over time, the optimal investment policy consists of a sequence of target costs, below which investment takes place and above which it does not. The timing option reduce optimal cost targets, relative to the case when no timing option is present. The first cost target is lowered because the compensation function calls for the payment of an amount equal to the manager's option to generate future slack, should investment take place. This increases the cost of investing at the first opportunity, thus reducing its attractiveness. In order to ease the incentive problem at the initial investment opportunity, the second target cost is also lowered, even though no further timing options remain. Making the additional assumption that costs are uniformly distributed, we generate additional insights. We find circumstances in which the profitability of investing initially exceeds the profitability of investing at the second opportunity, a result that is impossible in the first-best context. Second, we identify circumstances under which the initial target cost is increased by incentive effects. Third, we identify the conditions under which the option to wait is effectively shut down when incentive problems exist. The implications of relaxing several key assumptions, such as investment cost independence, the owner's commitment to the manager and not to renegotiate, are explored.

Suggested Citation

  • Antle, Rick & Bogetoft, Peter & Stark, Andrew W., 2001. "Incentive Problems and Investment Timing Options," Unit of Economics Working Papers 24192, Royal Veterinary and Agricultural University, Food and Resource Economic Institute.
  • Handle: RePEc:ags:rvaewp:24192
    DOI: 10.22004/ag.econ.24192
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    References listed on IDEAS

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    1. Kanodia, C, 1993. "Participative Budgets As Coordination And Motivational Devices," Journal of Accounting Research, Wiley Blackwell, vol. 31(2), pages 172-189.
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    Cited by:

    1. Nicole Bastian Johnson & Thomas Pfeiffer & Georg Schneider, 2013. "Multistage Capital Budgeting for Shared Investments," Management Science, INFORMS, vol. 59(5), pages 1213-1228, May.
    2. Barbara Harreiter & Thomas Pfeiffer & Georg Schneider, 2007. "Are real options more valuable in the presence of agency conflicts?," Review of Managerial Science, Springer, vol. 1(3), pages 185-207, November.
    3. Antle, Rick & Bogetoft, Peter & Stark, Andrew W., 2001. "Information systems, incentives and the timing of investments," Journal of Accounting and Public Policy, Elsevier, vol. 20(4-5), pages 267-294.
    4. Nicole Bastian Johnson & Thomas Pfeiffer & Georg Schneider, 2017. "Two-stage capital budgeting, capital charge rates, and resource constraints," Review of Accounting Studies, Springer, vol. 22(2), pages 933-963, June.
    5. Wonder, Nicholas, 2006. "Contracting on real option payoffs," Journal of Economics and Business, Elsevier, vol. 58(1), pages 20-35.
    6. David Martimort & Stéphane Straub, 2016. "How To Design Infrastructure Contracts In A Warming World: A Critical Appraisal Of Public–Private Partnerships," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 57(1), pages 61-88, February.
    7. Löffler, Clemens & Pfeiffer, Thomas & Schneider, Georg, 2012. "Controlling for supplier switching in the presence of real options and asymmetric information," European Journal of Operational Research, Elsevier, vol. 223(3), pages 690-700.
    8. Madhav V. Rajan & Stefan Reichelstein, 2004. "ANNIVERSARY ARTICLE: A Perspective on ÜAsymmetric Information, Incentives and Intrafirm Resource AllocationÝ," Management Science, INFORMS, vol. 50(12), pages 1615-1623, December.
    9. Clemens Löffler & Thomas Pfeiffer & Georg Schneider, 2013. "The irreversibility effect and agency conflicts," Theory and Decision, Springer, vol. 74(2), pages 219-239, February.
    10. Thomas Pfeiffer & Georg Schneider, 2007. "Residual Income-Based Compensation Plans for Controlling Investment Decisions Under Sequential Private Information," Management Science, INFORMS, vol. 53(3), pages 495-507, March.
    11. David Martimort & Stéphane Straub, 2016. "How To Design Infrastructure Contracts In A Warming World: A Critical Appraisal Of Public–Private Partnerships," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 57, pages 61-88, February.

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