Investment Timing and Incentive Costs

We analyze how the costs of smoothly adjusting capital, such as incentive costs, affect investment timing. In our model, the owner of a firm holds a real option to increase a lumpy form of capital and can also smoothly adjust an incremental form of capital. Increasing the cost of incremental capital can delay or accelerate investment in lumpy capital. Incentive costs due to moral hazard are a natural source of costs for the accumulation of incremental capital. When moral hazard is severe, delaying investment in lumpy capital is costly, and it is optimal to overinvest relative to the first-best case.