to as the manager of the firm. At the same time that the manager observes s, he learns g, the probability that the project will still exist should he decide to keep gathering information(i.e. delay the decision to undertake the project for one more period). If he chooses to gather more information, the manager learns i perfectly. In the event that the project disappears at any stage (probability 1-p in the first stage, and 1-q in the second stage), the firm's cash is simply invested at the riskfree rate until the end of the period; no other risky projects are available The sequence of events is illustrated in Figure 1. The manager of the firm makes three decisions(which are represented by open circles in the figure) during the period. At utset the first stage, he must choose whether to undertake the risky project, drop it, or gather some information about it. If information is gathered and if the project does not disappear while it is gathered, the manager makes his second-stage decision: the project can again be undertaken dropped, or the manager can choose to gather more (i.e, in this case, perfect) information about it. If more information is gathered and the project remains available, the manager then chooses in the third and final stage-the last decision node--whether or not to undertake the project In this and the next sections, we assume that the manager's utility is a function of the firms value exclusively. This is equivalent to assuming that the manager is compensated with firm's stock. In section 5, we take a closer look at the manager's incentives and analyze how more general compensation contracts can be used to align the manager's decisions with the interests of shareholders. This two-step approach allows us to disentangle the effects of risk aversion, behavioral biases, and compensation on decision-making Clearly, even if the project can be dropped in favor of a safe investment in the first two stages this will never be considered by the manager: the worst possible outcome from gathering more information is that the risky project disappears; the safe investment can then be made any way.It is also clear that the decision to undertake or drop the risky project in the third stage is trivial: at that point, the risky project's payoff is known with certainty, and so the project will be undertaken if and only if v= 1. Effectively therefore, the manager makes active decisions in each of the first two stages only, and the decision involves a comparison between undertaking the project at that stage or acquiring more information about it. This simple two-period framework thus captures the idea that a firm may choose to wait to invest in a risky project(McDonald and Siegel, 1986), but waiting may be costly(Grenadier, 2002), since a good project may be lost to competition. Suppose that, when making his second-stage decision, the manager knows that q is close to This results from the fact that information can be gathered without the firm or manager incurring any direct onetary or effort costs. Such costs are considered in section 6.2to as the manager of the firm. At the same time that the manager observes ˜s, he learns ˜q, the probability that the project will still exist should he decide to keep gathering information (i.e., delay the decision to undertake the project for one more period). If he chooses to gather more information, the manager learns ˜v perfectly. In the event that the project disappears at any stage (probability 1−p˜ in the first stage, and 1−q˜ in the second stage), the firm’s cash is simply invested at the riskfree rate until the end of the period; no other risky projects are available. The sequence of events is illustrated in Figure 1. The manager of the firm makes up to three decisions (which are represented by open circles in the figure) during the period. At the outset, the first stage, he must choose whether to undertake the risky project, drop it, or gather some information about it. If information is gathered and if the project does not disappear while it is gathered, the manager makes his second-stage decision: the project can again be undertaken, dropped, or the manager can choose to gather more (i.e., in this case, perfect) information about it. If more information is gathered and the project remains available, the manager then chooses in the third and final stage—the last decision node—whether or not to undertake the project. In this and the next sections, we assume that the manager’s utility is a function of the firm’s value exclusively. This is equivalent to assuming that the manager is compensated with firm’s stock. In section 5, we take a closer look at the manager’s incentives and analyze how more general compensation contracts can be used to align the manager’s decisions with the interests of shareholders. This two-step approach allows us to disentangle the effects of risk aversion, behavioral biases, and compensation on decision-making. Clearly, even if the project can be dropped in favor of a safe investment in the first two stages, this will never be considered by the manager: the worst possible outcome from gathering more information is that the risky project disappears; the safe investment can then be made anyway.3 It is also clear that the decision to undertake or drop the risky project in the third stage is trivial: at that point, the risky project’s payoff is known with certainty, and so the project will be undertaken if and only if ˜v = 1. Effectively therefore, the manager makes active decisions in each of the first two stages only, and the decision involves a comparison between undertaking the project at that stage or acquiring more information about it. This simple two-period framework thus captures the idea that a firm may choose to wait to invest in a risky project (McDonald and Siegel, 1986), but waiting may be costly (Grenadier, 2002), since a good project may be lost to competition. Suppose that, when making his second-stage decision, the manager knows that ˜q is close to 3This results from the fact that information can be gathered without the firm or manager incurring any direct monetary or effort costs. Such costs are considered in section 6.2. 7