Information revelation, real options, and employee incentives

Project flexibility can play an important role in capital budgeting choices. By adopting flexible projects, a decision maker can adjust production as uncertainty is resolved. Such production benefits of flexibility are the focus of the real options approach to capital budgeting. This paper considers another role of real options. When information relevant to a real option exercise decision is not publicly observed, the real option can be a mechanism that facilitates communication. This information dissemination role of real options is examined from a principal-agent perspective.; In the first setting, it is the principal who privately observes the information. In addition to its role in production, an option to expand serves to convey the principal's private information. The option is an effective communication device because it allows the principal to “put her money where her mouth is.” This signaling effect of the real option introduces a preference for procrastination by the principal. The principal chooses to delay her option exercise decision in order to optimally time the release of her private information.; In the second setting, it is the agent who privately observes the information. In this case, the principal still makes the exercise decision, but elicits reports from the agent before doing so. The principal again finds the option to expand useful for both productive and informational reasons. She commits to expanding if and only if the agent reports a highly productive environment. The agent's desire to underreport the productive environment to get a steeper incentive contract is curbed by his desire to work in a larger project (and extract the resulting moral hazard rents). By helping restrain the agent's reporting, the option eases the moral hazard problem with the agent.; Broadly stated, the results of this thesis stress that regardless of where information resides, the presence of operating flexibility can facilitate communication between parties. Hence, valuing an operating option requires examination of both its production and information roles.