Designing Incentive-Alignment Contracts in a Principal-Agent Setting in the Presence of Real Options

Cottrell, Tom and Calistrate, Dan (2000) Designing Incentive-Alignment Contracts in a Principal-Agent Setting in the Presence of Real Options. Canadian Industrial Problem Solving Workshops > 4th IPSW [Edmonton 29/5/2000 - 3/6/2000].

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Abstract/Summary

We develop a model of incentive compensation for optimal upgrades supplied by an outsourced Information Technology department. We first consider the problem when the rate of technological development is certain and there are no information asymmetries between the parties. We extend this to allow private information between the principal and an agent acting as an external supplier of information technology upgrades. Based on the model in these simple circumstances, we then model uncertain technological improvements, where improvements evolve as Geometric Brownian motion, and there is benefit to flexibility in the timing of the upgrade. We are aware of contracts, known as "evergreen upgrades", where a principal pays for upgrades at specified intervals. We find little support for such a contract in our model, and the loss of flexibility in the timing of upgrades is puzzling. The Stern-Stewart problem encourages us to consider just such instances, where contracts limit flexibility that it may in the interest of both parties to retain.

Item Type:	Study Group Report
Study Group:	Canadian Industrial Problem Solving Workshops > 4th IPSW [Edmonton 29/5/2000 - 3/6/2000]
Company Name:	Stern Stewart and Co.
Industrial Sector:	Finance
ID Code:	164
Deposited By:	Michele Taroni
Deposited On:	07 October 2008

Problem Statement

Consider a firm with shareholders (considered to be the Principal, as one entity) and management (the Agent). The Agent is compensated based on real increases in value. Should the Principal accept low increases now, based on estimates of considerable increases in the future(perhaps after the term of present management)? Should the Principal insist on the highest possible short term increase, and compensate or punish the Agent accordingly? Given that the Principal's knowledge will not in general be as complete as that of the Agent, and that there is uncertainty involved at several levels, what is the best strategy for the Principal and for the Agent to follow?

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