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Institutional and Methodological Background for the Analysis of Investment Incentives

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Real Options and Investment Incentives

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References

  1. The valuation literature on investments as well as whole companies has extensively analyzed problems under uncertainty. For textbook treatments see, e.g., Luenberger (1998), pp. 137–474; Copeland & Weston (1988), pp. 77–355; Brealey & Myers (1996), pp. 141–314; Franke & Hax (1999), pp. 287–354; Damodaran (2002).

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  2. For these and further examples of subsequent decision making see, e.g. Brealey & Myers (1996), pp. 255–264; Damodaran (2002), pp. 772–816.

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  3. Of course, there is no general rule how the distribution of investment decision rights depends on the size of a company. Even in some very large divisionalized companies, approval of major investment decisions by the board of directors is required. This can be seen as a mixed system of a combined central and decentral decision-making, which is quite common in corporate practice. See Stanley & Block (1984); Petty, et al. (1975).

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  4. See Magee (1964); Wilson (1969); Laux (1971); Hax & Laux (1972).

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  5. This idea has been expressed in Myers (1977) and relies on methods that have initially been developed and used for the valuation of financial options (Black & Scholes (1973); Merton (1973)). For an extensive review of this literature see Dixit & Pindyck (1994); Trigeorgis (1996).

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  6. For comprehensive reviews of different aspects of this literature see, e.g., Lambert (2001); Antle & Fellingham (1997); Gibbons (1998).

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  7. See Rogerson (1997) and Reichelstein (1997). Dutta & Reichelstein (2002a) summarize results of this literature for a variety of business transactions.

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  8. See, e.g., the models by Rogerson (1997); Reichelstein (1997); Reichelstein (2000); Antle & Eppen (1985); Zhang (1997); Bernardo, et al. (2001); Harris & Raviv (1996); Harris & Raviv (1998).

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  9. Textbook treatments of these topics also follow this classification. The valuation problems are treated mainly in corporate finance or valuation textbooks without taking the view of decentral decision making within organizations. See, e.g., Brealey & Myers (1996); Copeland & Weston (1988); Luenberger (1998); Schmidt (1990). On the other hand, problems of decentral decision making are described mainly in textbooks on managerial accounting. Here however, more complex investment structures are completely neglected. See, e.g., Ewert & Wagenhofer (2003); Hansen & Mowen (2000); Horngren & Foster (1991); Küpper (2001).

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  10. See, e.g., Brennan & Trigeorgis (2000); Bromwich & Walker (1998); Trigeorgis (1996).

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  11. Recent work includes Antle, et al. (2000); Antle, et al. (2001); Arya & Glover (2001); Arya, et al. (2001); Arya & Glover (2002); Crasselt (2003a); Crasselt (2003b); Dutta (2001); Grenadier & Wang (2003); Mittendorf (2003).

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  12. See, e.g., Trigeorgis (1996), pp. 2–3; Amram & Kulatilaka (1999), pp. 10–11; Friedl (2000), p. 23.

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  13. See Hansen & Mowen (2000); pp. 518–519.

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  14. For a classification of possible interdependencies see Küpper (2001), pp. 32–34.

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  15. See Milgrom & Roberts (1992), pp. 546–552.

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  16. See, e.g., Baldenius & Reichelstein (2002); Baldenius, et al. (2002); Anctil & Dutta (1999); Göx (2000); Pfeiffer (2002). For an overview, see Wagenhofer (2002).

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  17. See, e.g., Küpper (2001), pp. 309–312; Hansen & Mowen (2000), pp. 516–517.

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  18. Ewert & Wagenhofer (2003), pp. 459 make an additional distinction for responsibility centers with respect to the input side by distinguishing cost centers and expense centers.

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  19. A survey by Reece & Cool (1982) yielded the result that from a sample of 620 of the largest American companies 74% have at least two investment centers. It is not entirely clear, though, if the definition of investment center in this survey was the same as in this work.

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  20. See Melumad & Reichelstein (1987). For a model analyzing this question in the context of capital investment decision rights, see Baiman & Rajan (1995).

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  21. Additional incentive problems might arise between shareholders and central management (see, e.g., Jensen & Meckling (1976); Fama (1980); Fama & Jensen (1983)) as well as between divisional managers and the divisional employees.

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  22. See, e.g., Dutta & Reichelstein (2002b); Dutta & Reichelstein (2002c); Hofmann (2001), pp. 141–179.

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  23. Antle & Fellingham (1997) provide a comprehensive review of this literature.

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  24. See Dutta & Reichelstein (2002a); Laux (1999), pp. 285–316; Pfaff (1998); Pfeiffer (2003); Reichelstein (1997); Rogerson (1997).

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  25. See Schiller (2001).

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  26. See also Lambert (1986).

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  27. See Küpper (2001), pp. 313–406.

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  28. See, e.g., Hofmann (2001), p. 162.

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  29. See Eccles & White (1988), p. S19.

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  30. See, e.g., Copeland & Weston (1988), p. 26.

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  31. See, e.g., Zhang (1997).

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  32. See, e.g., Lorie & Savage (1955); Weingartner (1977); Brealey & Myers (1996), pp. 101–105. For a survey on external capital rationing see Matson (1999).

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  33. One of the basic result in information economics is the revelation principle, which states that any implementable allocation between a principal and an agent can also be implemented by using a direct revelation mechanism that induces the agent to tell the truth. For the revelation principle, see in particular Myerson (1979). For additional incentive problems within budgeting procedures see Hofmann (2001), pp. 54–55.

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  34. See, e.g., Jensen & Meckling (1976). An alternative but related view is that the manager has a preference for controlling a larger budget, which is sometimes referred to as the desire for empire building, see Arya, et al. (1999); Baldenius (2002); Harris & Raviv (1996).

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  35. For mechanisms for independent divisions, see, e.g., Weitzman (1976); Osband & Reichelstein (1985); Kirby, et al. (1991); Reichelstein (1992); Trauzettel (1999), pp. 193–217. The Groves-mechanism (see Groves (1973) and Groves & Loeb (1979)) can be applied for multi-divisional firms with dependencies between divisions.

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  36. See Ewert & Wagenhofer (2003), pp. 574–576.

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  37. See Gitman & Forrester Jr. (1977); Ferreira & Brooks (1988); Fremgen (1973).

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  38. See Antle & Eppen (1985); Antle & Fellingham (1990); Antle & Fellingham (1995); Antle, et al. (1999); Harris, et al. (1982); Harris & Raviv (1996); Harris & Raviv (1998); Sappington (1983). For a selective review see Antle & Fellingham (1997).

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  39. See Antle & Eppen (1985).

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  40. See Myerson (1979); Harris & Townsend (1981).

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  41. See, e.g., Fudenberg & Tirole (1992), pp 243–318; Laffont & Tirole (1993).

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  42. See also Laffont & Tirole (1986).

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  43. Poterba & Summers (1995), p. 43.

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  44. See Ross (1986).

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  45. See Gitman & Forrester Jr. (1977).

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  46. See Ferreira & Brooks (1988) and Fremgen (1973).

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  47. For a justification of this objective, see, e.g., Brealey & Myers (1996), pp. 17–27; Schmidt (1990), pp. 27–28.

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  48. See in particular the early contribution by Hart (1940).

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  49. For comprehensive treatments of this topic see Dixit & Pindyck (1994); Trigeorgis (1996); Copeland & Antikarov (2001); Hommel, et al. (2003).

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  50. General requirements for performance measures are depicted for instance in Hax (1989), pp. 163–168; Laux (1995), p. 156; Küpper (1998), pp. 527–528; Küpper (2001), pp. 227–229. Observability is discussed in detail by Riegler (2000), p. 37.

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  51. See Küpper (2001), p. 228.

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  52. For a discussion of their relative advantages see Reichelstein (2000); Wagenhofer & Riegler (1999).

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  53. For a similar differentiation see Banker & Datar (1989), p. 22.

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  54. See Holmström (1979), pp. 83–84.

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  55. For a detailed description of the informativeness principle see Budde (2000), pp. 44 et seqq.

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  56. There are a lot more than these three types of performance measures, like for instance return on investment (RoI), or cash value added (CVA). I restrict attention to the choice between these three measures, because the recent theoretical debate has largely focused on these measures, see, e.g., Pfeiffer (2003); Reichelstein (2000); Wagenhofer (2003). For an overview, see Hachmeister (2002), pp. 1388–1393; Hebertinger (2001), pp. 65–194.

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  57. This assumption is consistent with the clean surplus relation, see, Ohlson (1995); Feltham & Ohlson (1995).

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  58. This equivalence result is also known under the term Preinreich-Lücke-Theorem, see Preinreich (1937); Lücke (1955).

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  59. A survey on the theoretical literature on residual income can be found in Bromwich & Walker (1998). Practitioners are marketing residual income measures under different labels, the most prominent of which is probably Economic Value Added (see Stewart III (1991); Hostettler (1997); O’Hanlon & Peasnell (1998); Stern, et al. (2001)). A survey of capital budgeting practices of the Fortune 1000 companies indicated that 53,9% are using EVA at least sometimes, see Ryan & Ryan (2002).

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  60. For a discussion of possible reasons see Green, et al. (2002).

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  61. For a detailed criticism see Solomons (1965), pp. 134 et seqq.

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  62. See Reichelstein (1997), p. 168; Baldenius, et al. (1999), p. 59.

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  63. See Reichelstein (1997).

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  64. Stern et al. (2001), p. 21 propose to include R&D expenses in the balance sheet and amortize it “over the period of years during which these research outlays are expected to have an impact.”

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  65. See, e.g., Christensen, et al. (2002), p. 6; Egginton (1995), p. 203; Rogerson (1997), p. 785; Velthuis (2003), p. 121.

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  66. Busse von Colbe (2002), p. 6 and Küpper (2002), p. 52–53 propose the use of market values as asset base for regulated industries. For a critical discussion see Pedell (2003), p. 6–22.

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  67. See, e.g., Anthony & Govindarajan (2000), p. 256; Hilton, et al. (2000), p. 839; Horngren, et al. (1999), p. 663–664. For an early discussion see Rudolph (1986), pp. 892–898.

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  68. See, Stern et al. (2001); pp. 19–20; Horngren et al. (1999), pp. 664–666.

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  69. See Christensen et al. (2002).

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  70. A criticism of using the WACC can also be found in Velthuis (2003), pp. 123–128.

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  71. See, e.g., Bushman & Indjejikian (1993); Bushman, et al. (2000); Christensen et al. (2002); Feltham & Xie (1994); Reichelstein (1997); Dutta & Reichelstein (2002b).

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  72. See, e.g., Jensen (2001).

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  73. See Milgrom & Roberts (1992), p. 221.

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  74. See also Taggart Jr. (1987) and Kester & Taggart Jr. (1989).

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  75. See Baldenius (2002) for a model, which combines performance-based compensation with private benefits of controlling larger projects. The latter is quite similar to a desire for slack.

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  76. See, e.g., Antle & Eppen (1985); Harris & Raviv (1996); Harris & Raviv (1998); Bernardo et al. (2001).

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  77. For an overview over applications of principal-agent models in different areas of business research see Jost (2001b).

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  78. See Laffont & Martimort (2002).

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  79. See Hart & Holmström (1987); Brousseau & Glachant (2002).

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  80. See Arrow (1985), p. 38; Jost (2001a), pp. 23–31.

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  81. Antle & Fellingham (1997), p. 905, argue that “given the variety of institutions available for risk sharing (banks, insurance companies, casinos), the possibility exists that it may not be economically insightful to resolve the risk sharing problem in a capital investment setting.”

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  82. See Holmström (1979).

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  83. See Grossman & Hart (1983); Rogerson (1985); Jewitt (1988). See also Mirrlees (1999).

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  84. See Spremann (1987); Holmström & Milgrom (1987); Wagenhofer & Ewert (1993).

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  85. For a detailed general criticism of agency-theory see Meinhövel (1999), pp. 107–170.

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  86. See, e.g., Lambert (2001) pp. 77–79.

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  87. Recent papers on these issues include Indjejikian & Nanda (1999); Dutta & Reichelstein (2002c); Sliwka (2002); Christensen, et al. (2003).

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  88. Reichelstein (1997), p. 157.

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  89. See, e.g., Rogerson (1997); Reichelstein (1997); Gillenkirch & Schabel (2001); Dutta & Reichelstein (2002a).

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  90. See Holmström (1979), p. 83–84.

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  91. An example for such a reason is the need for providing operational incentives in addition to investment incentives, which can be addressed by the steepness of the compensation function. See Dutta & Reichelstein (2002b) for a formalization of this argument.

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(2007). Institutional and Methodological Background for the Analysis of Investment Incentives. In: Real Options and Investment Incentives. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-540-48268-0_2

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