Is corporate control effective when managers face investment timing decisions in incomplete markets?

This paper presents a model of investment timing by risk averse managers facing incomplete markets and corporate control. Managers are exposed to idiosyncratic risks due to the dependence of their compensation on investment payoffs which are not spanned by other assets. We show that risk averse managers invest earlier than welldiversified shareholders would prefer, leading to significant agency costs. This effect can be mitigated if the manager is subject to corporate control. Our main finding is that the interaction of idiosyncratic risk and control results in two regimes. When the market is sufficiently close to being complete, control has a strong disciplinary effect and agency costs can be virtually eliminated. However, when idiosyncratic risk is too large, shareholders suffer agency costs and control is ineffective. An implication is that we would expect to see different investment behavior across industries or specific investments as the degree of idiosyncratic risk varied. It would also suggest that both the standard complete-markets real options model and the npv framework can proxy in describing investment timing. & 2010 Elsevier B.V. All rights reserved. Agency conflicts arise when managers make decisions on behalf of shareholders. In this paper we consider the impact of idiosyncratic risk inherent in an investment decision faced by a risk averse manager and show it leads to investment timing decisions which are inefficient for well-diversified shareholders. We question whether the market for corporate control provides a remedy. We find in some situations, strong shareholder rights will indeed lead to a significant reduction in agency costs, however, when idiosyncratic risk is too large, corporate control is not a sufficient deterrent to inefficient investment, and agency costs remain high. We consider a risk averse manager who faces a single decision of when to make an irreversible investment which has a fixed cost, and which pays off in a lump-sum. The manager’s reward depends on the firm’s activities, and as such, he is compensated with a fraction of the option to invest. In our model, investment payoffs cannot be perfectly spanned by existing assets and so idiosyncratic or unhedgeable risks remain. The risk averse manager makes his investment timing decision based on his own preferences, taking into account his exposure to idiosyncratic risk. Shareholders, on the other hand, are well-diversified and do not require compensating for idiosyncratic risk. Agency conflicts arise because the risk averse manager maximizes the value of the investment timing option based on his own preferences, whilst shareholders want to maximize firm value. As is usual in real options, exercise or investment occurs when the project value reaches a certain threshold. Here, the thresholds chosen by the risk averse manager and well-diversified shareholders will be different.