Corporate Control and Real Investment in Incomplete Markets

Abstract

In the standard real options approach to investment under uncertainty, agents formulate optimal policies under the assumptions of risk neutrality or perfect capital markets. However, in most situations, corporate executives face incomplete markets either because they receive compensation packages that restrict their portfolios or because cash flows from the firm's investment opportunities are not spanned by those of existing assets. The present paper examines the impact of managerial risk aversion on investment decisions when the manager is exposed to idiosyncratic risk and faces the risk of a control challenge. In the paper, the investment policy selected by the manager reflects a trade-off between his incentives to reduce risk and the need to ensure sufficient efficiency to prevent control challenges. The analysis demonstrates that risk aversion induces the manager to speed up investment, leading to a significant erosion of the value of the option to wait. r

Valuing the option to invest in an incomplete market

“…Taking ϑ = 0 gives the state price density D 0 t under which Z -risk is not compensated. We have B 0 t = B t + λt and Z 0 t = Z t are independent Brownian motions, giving P and V follow d 9 We remark here that in both of the standard real options models described in this Section, it is equivalent to consider an investment paying a stream of cash flows over time or an investment paying the present value of those cash flows at the time of investment (a one-off or lump-sum case). Since E ∞ 0 D 0 s V s ds = V 0 /η(λρ − ξ), it is equivalent to consider a payoff based on cash flows of (V s I (s>τ ) − K ) + and a one-off payoff of (R (V τ …”

“…Miao and Wang [15] also show investment may be delayed due to incomplete markets when investment payoffs are delivered over time in flows rather than in a lump-sum. We also mention the model of Hugonnier and Morellec [9] where the focus is on agency issues and the effect of control challenges on manager behavior in an incomplete setting. Their manager chooses the investment time but does not directly benefit from exercise of the option, although he may be replaced if his exercise strategy deviates from the optimal shareholder policy.…”

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

“…Although Hugonnier and Morellec (2007) use CRRA utility, this is not the reason for the differences in our conclusions and there is no reason to expect our main results would change under CRRA preferences. However, employing CRRA utility in our set-up would greatly complicate the analysis since it would require solving a two-dimensional problems, which has to be done numerically.…”

Optimal investment of private equity

“…Dixit and Pindyck (1994) treat the real option method as an analytical tool applied to the economy activities. Henderson (2007) and Hugonnier and Morellec (2007) analyze the investment decision under incomplete markets. Bolton, Wang and Yang (working paper) consider the irreversible investment under uncertainty for a firm facing external financing cost and extend the traditional real option model.…”