The Research On Incentive And Audit Mechanism In Exercising Project Investment Options

In the project investment, investment opportunity in the enterprises will contain uncertainty, irreversibility and the ability to defer. These three characteristics form certain real option value in the value of project investment. Investment option is a choice right owned by the enterprises who have investment opportunity. This option resembles the financial call option. The enterprises that have investment option will get the investment right without the obligation. These options can give the projects additional option value, so the enterprises must regard these investment opportunities as real options to evaluate. Only evaluating them like that, the enterprises could determine the optimal timing of investment and realize the maximum projects value.The owner of investment options is able to determine the optimal exercising threshold price and make the optimal investment decisions if it has known the parameters accurately. In the enterprises that the ownership is separated from the management power, owner has the ownership of the investment options and gives the decision and management rights to the manager, so as to make full use of the managers' experience and ability. Under the background like this, the asymmetric information is likely to occur. This asymmetric information related to the exercising and management process contains two points. First, manager will know more information of projects cash flows than the owners. Owners can only get the probability distribution of this information, they can't observe it accurately. Second, the more efforts managers make, the more cash flow the project will produce, but the owner can't observe and verify the manager's effort level. Due to the different goal functions that owner and manager have in exercising the investment option, this information will lead to the occurrence of Adverse Selection and Moral Hazard which form the agency conflicts between the owner and manager. Without the necessary incentive mechanism and audit mechanism, the adverse selection and moral hazard problem in exercising options will cause the distortion of exercising threshold and the loss of owner's option value.The contract theory based on the principal-agent model provides the efficient solutions to the adverse selection and moral hazard due to the asymmetric information. The owner can supply a practical contract that meets the incentive compatible constraints and a certain information rent, which will inspire the manager to report real information and make higher efforts. This contract will control and supervise the behavior of hiding information and action. Compared with the agency conflicts in the traditional enterprises, the behavior of hiding information and action in exercising investment options show some special characters. Firstly, the manager's moral hazard problem will lead to the distortion of investment option's exercising threshold. Secondly, the manager's adverse selection problem will also lead to the same problem. Finally, the information rents from the owner must be determined based on the publicly observed exercising threshold.The above characters of agency conflicts in exercising the investment options will cause the incentive and audit mechanism to show option characteristic, which mainly lie in the discount of information rent. In the contracts of exercising investment options, the theoretic questions below are the research topics:how to build the participation constraints, incentive compatible constraints and limited liability constraints? What are the characters of the optimal incentive and audit mechanism to the adverse selection and moral hazards in exercising investment options? What are the characters of investment options' contracts under multidimensional asymmetric information? How to build and implement the incentive and audit mechanism when the project value is subject to the jump process? And so on.This paper mainly uses the contract theoretical analysis method based on the principal-agent models, and studies the adverse selection and moral hazard problem in exercising the investment options. We adopt the incentive and the audit mechanism to supervise and control the behavior of hiding information and hiding action, so as to provide the theoretical directions to optimize the process of exercising investment options and promote the efficiency of exercising options. On the other hand, this paper studies the incentive-salary mechanism of investment option and provides the salary option based on the stock of the enterprises, in order to supply the direction to the implementation process of the optimal incentive mechanism and audit mechanism. Finally, by using numerical simulation method together with the theoretical conclusions, this paper studies two practical application topics which were pointed out by Grenadier and Neng Wang(2005):controlling investment lags and stock variation information.Based on the theoretical and application conclusions, five policy suggestions are pointed out:First, governments should build the incentive mechanism associated with audit mechanism, so as to supervising and regulating the adverse selection and moral hazard problems. Facing the slow economic increase led by the global financial crisis, our country is implementing the policy "broadening domestic demands, ensuring economic increase", and using the projects investment fund of about four trillion RMB to stimulate the economic recovery. The conclusions related to this paper can provide the theoretical base and policy suggestions to direct the government audit sections to audit the projects investment.Second, facing the multi-dimensional asymmetric information in exercising investment options, governments must evaluate the project's feasibility scientifically and get the information detailed related to project quality and investment cost. Only the optimal incentive or audit mechanism based on that information is more efficient.Third, when government gets the projects which require shorter construction cycle or the projects of saving ruin, decreasing ruin and military ones, government may implementing the optimal incentive mechanism with certain conditions. This will get time with information rents.Fourth, government can build the incentive-salary mechanism with the underlying securities of enterprise's stocks, if the agent enterprise is listed company.Fifth, government may use the incentive mechanism in exercising investment projects to decrease the investment lags. Additionally, government can also use the usual methods of controlling quality of projects to decrease the investment lags, such as controlling the projects quality.Compared with the home and overseas documents, this paper's main innovations are summarizes as below:First, this paper uses the audit mechanism in the product contract theory to control the adverse selection problem in exercising. The incentive methods and audit skills are integrated to supervise and regulate the course of exercising investment options. The related research home isn't found to this day, so it has a certain theoretical value.Second, this paper builds an incentive salary option mechanism in exercising investment options with the underlying assets of agent enterprise stocks, based on the optimal incentive and audit mechanism. This option can be priced by the one-period binomial tree model under the one dimensional asymmetric information, and can be priced by three periods binomial tree model under the two-dimensional asymmetric information. This option can be implemented easily and has pertinence, so it can provide the policy directions in strengthening supervising the government's projects.Third, this paper finds that owners can shorten the projects construction cycle if owners can supply large information rents enough. This conclusion is valuable to policy makers. When facing the projects which require shorter construction cycle or the projects of saving ruin, decreasing ruin and military ones, government may implementing the optimal incentive mechanism with certain conditions. This will get time with information rents.Fourth, this paper pointed an optional monotone likelihood ratio property. Milgrom(1981) pointed out a monotone likelihood ration property to explain owner's intention to inspire agents to make higher efforts. But it can't explain this intention in exercising investment options. The optional monotone likelihood ratio property can explain this intention well.Fifth, chapter 6 studies the contracts of investment option which has the underlying projects value under the jump-diffusion process. According to the domestic and overseas documents, this chapter is an earlier research to this topic, and it has some theoretical value.Sixth, this paper studies the two application topic which were pointed out by Grenadier and Neng Wang(2005). It proves that the optimal incentive mechanism can control the principal-agent conflicts better in exercising investment options, and that this optimal incentive mechanism can be used as the methods by which government or enterprises can use to shorten the investment cycle and promote the efficiency of investment.