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Agency Contracts, Noncommitment Timing Strategies, and Real Options

Listed author(s):
  • Keiichi Hori

    (Faculty of Economics, Ritsumeikan University)

  • Hiroshi Osano

    (Institute of Economic Research, Kyoto University)

Given an owner's noncommitment timing strategy and a manager's hidden action, we consider how the optimal compensation contract for the manager is designed and how the corresponding timing decisions to launch the project and replace the manager are determined. Using a real options approach, we show that in comparison with the firstbest case, the higher (lower)-quality project is launched later (at the same time as the first-best case), whereas the incumbent manager is replaced earlier. We also indicate that compared with the case of the owner’s commitment timing strategy and the manager's hidden action, the higher (lower)-quality project is launched later (at the same time as the first-best case), whereas the incumbent manager is (is not necessarily) replaced 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.

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Paper provided by Kyoto University, Institute of Economic Research in its series KIER Working Papers with number 768.

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Length: 47pages
Date of creation: Apr 2011
Handle: RePEc:kyo:wpaper:768
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