Dynamic Agency and Real Options∗

We present a model integrating dynamic moral hazard and real options. A risk averse manager can exert costly hidden effort to increase productivity growth of a firm. In addition, the risk neutral owners of the firm can irreversibly increase the firms capital stock. In contrast to the literature, moral hazard may accelerate or delay investment relative to the first best depending on the severity of the moral hazard problem. When the agency problem is more severe, the firm will invest at a lower threshold than in the first best case because investment acts as substitute for effort. This mechanism provides an explanation for over-investment that does not rely on “empire building” preferences. Effort decreases after investment, however pay performance sensitivity increases after investment when the agency problem is less severe and the growth option is large. ∗We wish to thank Jonathan Berk, Simon Gervais, Zhiguo He, Dmitry Livdan, Alexei Tchistyi, Vish Vishwanathan, and Nancy Wallace as well as seminar participants at UC Berkeley Haas (Real Estate), Duke Finance Brownbag, and the Revelstoke Finance Summit for useful conversations. All errors are our own. †Erasmus School of Economics, Erasmus University Rotterdam. Email: [email protected]. ‡Fuqua School of Business, Duke University. Email: [email protected]. MACROECON & INT'L FINANCE WORKSHOP presented by Barney Hartman-Glaser FRIDAY, April 5, 2013 3:30 pm – 5:00 pm, Room: HOH-706