Let Managers Decide: Designing Contracts for Optimal Investment Decisions

Real options literature commonly assumes that, either the investment opportunity is directly managed by the owners, or the managers are perfectly aligned with them. However, agency conflicts occur and managers reveal interests not totally in line with those of the shareholders. This may have a major impact on the value maximizing decisions, namely, on the optimal timing to invest. This paper contributes to the scarce literature that accounts for agency problems on the exercise of real options. We propose a model which allows to set an optimal contract structure in order to avoid inadequate actions from the manager. In our model, shareholders need not to follow the future evolution of project value drivers in order to guarantee optimal behavior. It is shown that even small deviations from the optimal compensation scheme may lead to highly sub-optimal decisions. Optimal contracts are also established for special situations, namely, to account for impatient managers, for non-proprietary (or non-monopolistic) real options, and also by considering the existence of effort costs for the manager. JEL classification: G31; D82.