DP3709 The Economic Value of Flexibility When There is Disagreement

Author(s): Arnoud W A Boot , Anjan Thakor

Publication Date: January 2003

Keyword(s): corporate finance , Managerial decision-making

JEL(s): D83 , G30 , G32

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP3709.asp

We develop an economic theory of ‘flexibility’, which we interpret as the discretion or ability to make a decision that others disagree with. We show that flexibility is essentially an option for the decision-maker, and can be valued as such. The value of the flexibility option is decreasing in the extent to which the decision-maker’s future decision-relevant opinion is correlated with the opinions of others who may be able to impede the decision. We argue that flexibility drives economic decisions in a significant way. The applications we consider are: the entrepreneur’s choice of flexibility in the initial mix of financing raised; the use of flexibility to understand differences in security design and the firm’s security-issuance decision; the impact of flexibility on the use of collateral in lending; the role of flexibility in capital budgeting decisions; the effect of flexibility considerations in the design of contracts in a principal-agent setting; the interpretation of ‘power’ and conformity in organizations in the context of flexibility; and the choice between private and public ownership in the context of flexibility.