Agency Contracts, Noncommitment Timing Strategies, and Real Options

Abstract

Given that an owner cannot commit to her timing strategy under a manager's hidden action, we consider (i) how the owner's timing decisions to launch a project and to replace the manager or change a project are determined, and (ii) how the optimal compensation contract for the manager is designed. Using a real options approach, we show that, compared with the case in which the owner can commit to her timing strategy under the manager's hidden action, a higher (lower)-quality project is launched later than (at the same time as) the first-best case, whereas the replacement of the manager or change of the project is (is not necessarily) made 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 corporate control if the hidden-action problem is not too severe.

Keywords: agency, CEO turnover, executive compensation, noncommitment, real options, severance pay

JEL Classification: D82, G30, G34, M51, M52