We present a model integrating dynamic moral hazard and real options.
A risk-averse manager can exert costly hidden effort to increase productivity growth of a firm. In addition, risk-neutral owners of the firm can irreversibly increase the firms capital stock. In contrast to the literature, moral hazard may accelerate or delay investment relative to the first best depending on the severity of the moral hazard problem. When the agency problem is more severe, the firm will invest at a lower threshold than in the first best case because investment acts as substitute for effort. This mechanism provides an explanation for over-investment that does not rely on “empire-building” preferences. Effort decreases after investment, however pay performance sensitivity increases after investment when the agency problem is less severe and the growth option is large.