Incentive Problems and Investment Timing Options

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 reduces 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. First, circumstances are identified in which not only does the cost target for immediate investment exceed that for delayed investment but also the probability of immediate investment exceeds the conditional probability of delayed investment, results impossible in the first-best context. Here, relatively speaking, incentive problems shift the probability of investment away from delayed investment towards immediate investment. Second, incentive problems are generally thought to reduce target costs, relative to opportunities with no incentive problems, in order to limit the manager’s slack on lower cost projects. Incentive problems, however, have more complex effects in the opportunity analyzed here. As a result, we are able to identify circumstances under which the target cost for immediate investment may be increased by incentive effects, relative to the target cost that exists in the absence of incentive problems.