Moral hazard in investment timing choice and managerial incentive compensation

Abstract

In this paper, we analyse a moral hazard problem associated with the manager's choice of investment timing when she possesses private information about the profitability of an investment project. We consider a two-period agency framework where the agent is delegated to make both production and investment decisions that are interrelated and the principal provides investment funds. For the agent's compensation contract, a simple sharing rule is employed that includes, in each period, a fractional share of the firm's periodic payoff as well as a salary not directly related to the payoff. We first note that if the agent's compensation is independent of the investment level, she always prefers earlier investment, whereas the principal's preference over investment timing depends on the profitability of the investment project. Thus there could arise moral hazard behaviour of recommending early investment by the agent under informational asymmetry . We then derive an incentive-compatible managerial compensation contract that would lead the agent to truthfully reveal her private information so that the moral hazard problem could be resolved. Such,a contract is shown to require part of the investment cost to be charged to the agent upon her choosing earlier investment in the form of a reduction in her salary together with an increase in her fractional share. Our results basically lend support to what residual income literature argues but with some additional features of salary adjustments that are geared to control the moral hazard problem.