At-the-Money Stock Options, Incentives, and Shareholder Wealth
45 Pages Posted: 20 Nov 2007
Date Written: November 18, 2007
Abstract
Properly designed incentives should reward management if and only if it succeeds in increasing shareholder wealth. We show that conventional at-the-money stock options do not achieve this objective, because they allow management to benefit from value created before the options were awarded. Consequently the cost of the options can exceed any value created for shareholders. In addition if management is unsuccessful in adding positive NPV projects, it can still benefit from negative NPV projects. We also examine management's motivation for dividends and repurchases and find that dividends are undesirable to management unless the strike is adjusted, while repurchases are quite favorable to management. We show how these problems are solved by indexing the exercise price to the cost of capital, a type of option that has been discussed lightly in the practitioner literature. Empirical estimates reveal that failure to index the exercise price to the cost of capital results in a cost of about 18 percent of total compensation, equivalent to about one-quarter of a percent of shareholder value. This cost is positively and significantly related to measures of free cash flow and over investment, as predicted by the model.
Keywords: executive stock options, stock options, executive compensation, incentives
JEL Classification: G32, G39, M52
Suggested Citation: Suggested Citation
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