Managers' Investment Timing Decisions under Endogenous Compensation Contracts

This paper considers how managers choose the timing of investment in risky but value-increasing projects with a liquidation possibility for their firm when their personal objectives are not aligned with those of shareholders but their compensation is endogenously determined. Using a real options approach for a broad class of managerial preferences, we show that without hidden information, the startup of the project is more likely to be delayed with a higher liquidation possibility, whereas the grant size of stock-based managerial compensation is independent of the liquidation possibility but is decreasing in the volatility of the firm's cash flow stream and the degree of managerial impatience if the manager is risk neutral. We also indicate that restricted stock is optimal in a general class of compensation schedules, regardless of the manager's risk preferences. Further, if there exists hidden information on the volatility of project returns and if the risk-neutral manager is as impatient as the shareholders, the equilibrium must be pooling. Then, the startup of the high- (low-)volatility project is advanced (delayed) in comparison with the case without hidden information