Incentive Compatible Decision Making: Real Options with Adverse Incentives

In this paper, we examine the real options approach to capital budgeting decision making in the presence of managerial adverse incentives. We show that real options have the potential to be value enhancing or value destroying depending on the managerial incentives that may result from having objectives different from firm value maximization. We further examine the possibility of using a generic residual income based rule of managerial compensation to induce the proper investment incentives and we seek to determine the cost-of-capital that must be employed in such a rule. Using numerical examples it is demonstrated that in general, a range of incentive compatible costs-of-capital exists across all managerial investment horizons but not across all managerial hurdle rates