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 overinvesting relative to the first-best case is optimal. Received January 24, 2017; editorial decision March 15, 2019 by Editor Itay Goldstein.

We model the widespread failure of contracts to share risk using available indices. A borrower and lender can share risk by conditioning repayments on an index. The lender has private information about the ability of this index to measure the true state that the borrower would like to hedge. The lender is risk‐averse and thus requires a premium to insure the borrower. The borrower, however, might be paying something for nothing if the index is a poor measure of the true state. We provide sufficient conditions for this effect to cause the borrower to choose a nonindexed contract instead.