This paper considers the agency problem between a shareholder
and his CEO when the CEO privately chooses not only the effort level
but also the project to invest. First, I identify the optimal contract and
the analysis focuses on how the presence of an unobservable project
choice can crucially change the compensation schemes. Second, the
tradeoff between the two managerial actions is examined. I provide
the conditions under which a more risky or a less risky project than the
shareholder desires is selected. Third, I study how the unobservability
of the project choice decreases the shareholder’s expected profit and
how it distorts the managerial decisions further than the unobservable
effort does. At last, I look into the consequences for the shareholder
of ignoring the unobservable project choice in designing the executive
compensation scheme.
