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Real Options and Investment Incentives

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Many large corporations delegate investment decision-making authority to their divisions. Because they are better informed, divisional managers should be able to make better decisions than corporate headquarters. However, they can use this informational advantage to pursue their own interests. The objective of this work is to analyze the problem of delegated decision-making within firms when investment projects are characterized by the possibility to make subsequent decisions after the initial investment decision has been made. By analyzing this question, the monograph combines and unifies two important lines of literature: on the one hand the literature on controlling investment decisions, on the other hand the investment valuation literature.

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Contents
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2
3
Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . .
Institutional and Methodological Background for the Analysis of Investment Incentives. . . . . . . . . . . . . . . . . . . . 2.1 Investment Decision Making Within Divisionalized Firms 2.1.1 General Properties of Capital Investment Decisions 2.1.2 Decentralization, Asymmetric Information, and Its Consequences for Incentive Problems . . . . . . . . . 2.1.3 Types of Incentive Problems for Corporate Investment Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Instruments for Controlling Capital Investment Decisions 2.2.1 Classifying Instruments for Controlling Investment Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.2 Capital Budgeting and Capital Rationing . . . . . . . . 2.2.3 The Use of PerformanceBased Compensation . . . . 2.2.4 Comparison of Capital Rationing and PerformanceBased Compensation . . . . . . . . . . . . . . 2.3 Appropriateness of Various Theoretical Methodologies for the Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 Requirements for the Employed Methodology . . . . 2.3.2 PrincipalAgent Models . . . . . . . . . . . . . . . . . . . . . . . 2.3.3 Goal Congruence Models . . . . . . . . . . . . . . . . . . . . . .
1
7 7 7 11 13 15 15 17 23 30 32 32 33 35
Capital Rationing as an Incentive Instrument for Growth Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 3.1 Relevance of Growth Options for R&DInvestments . . . . . 37 3.2 Theoretical Results on Capital Budgeting and Growth Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
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Contents
3.3
3.4 3.5
Analysis of a Model on Incentive Problems for Growth Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.1 Model Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.2 Solution of the Model . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.3 Relaxation of the Participation Constraints . . . . . . 3.3.4 Comparison of the Investment Rules . . . . . . . . . . . . Changing Uncertainty over Investment Costs . . . . . . . . . . Implications for Capital Budgeting Procedures . . . . . . . . .
Residual Income as a Performance Measure for Switching Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1 Residual IncomeBased Performance Evaluation and Real Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 Modelling Investment in a Flexible Manufacturing System 4.2.1 Model Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.2 Headquarters’ Objective . . . . . . . . . . . . . . . . . . . . . . . 4.2.3 Goal Congruence and Manager’s Objective . . . . . . . 4.3 Design Alternatives for the Residual Income Performance Measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3.1 Myopic Accounting Rules . . . . . . . . . . . . . . . . . . . . . . 4.3.2 Recording the Option Value . . . . . . . . . . . . . . . . . . . . 4.3.3 Discussion of Recording the Option Value . . . . . . . . 4.4 Applying the Results to Different Types of Real Options 4.4.1 Strategic Investment Decisions . . . . . . . . . . . . . . . . . 4.4.2 Business Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . 4.5 Implications for the Design of the Residual Income Performance Measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Residual Income as a Performance Measure in the Presence of Waiting Options. . . . . . . . . . . . . . . . . . . . . . . . . 5.1 Relevance of Waiting Options for Investment Decisions . . 5.2 Description of the Basic Model . . . . . . . . . . . . . . . . . . . . . . . 5.3 Comparison of Alternative Residual IncomeBased Performance Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.3.1 Simple Depreciation Policy . . . . . . . . . . . . . . . . . . . . . 5.3.2 Capitalization of the Option Value . . . . . . . . . . . . . . 5.3.3 Raising the Hurdle Rate . . . . . . . . . . . . . . . . . . . . . . . 5.4 Extending the Project Life to Many Periods . . . . . . . . . . . 5.5 Advantages and Disadvantages of the Proposed Design Alternatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.6 Implications for Corporate Practice and Further Research
41 41 44 46 48 50 52
55 55 58 58 59 60 61 61 64 66 68 68 69 70
73 73 76 78 78 80 82 85 88 90
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Contents
Implications and Conclusions. . . . . . . . . . . . . . . . . . . . . . . . 6.1 Contribution to the Literature . . . . . . . . . . . . . . . . . . . . . . . 6.2 Limitations of the Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 6.3 Empirical Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.4 Extensions and Further Theoretical Research . . . . . . . . . .
Appendix. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
XI
91 91 93 94 96
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References109. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
http://www.springer.com/978-3-540-48266-6
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