Employee Stock Options, Financing Constraints, and Real Investment: Theory and Evidence
Arizona State University
Michael L. Lemmon
University of Utah - Department of Finance
Arizona State University (ASU)
University of British Columbia, UBC Winter Finance Conference 2008
AFA 2009 San Francisco Meetings Paper
EFA 2008 Athens Meetings Paper
In this paper, we demonstrate the advantage of broad-based stock option plans over cash compensation when the firm needs to finance both current and future investment in an environment where external finance is costly. Intuitively, the company obtains funds for investment in the current period by cutting fixed wages through the issuance of stock options. The company receives additional funds in later periods when it collects the cash proceeds and tax savings from option exercises. Importantly, the cash inflow arising from option exercises is correlated with improvements in the firm's investment opportunities, thus providing funds in precisely those states of the world where the demand for investment is high. Option grants in the current period therefore allow the firm to relax both its current and future financing constraints and to increase investment in positive NPV projects. Consistent with the predictions of the model, we estimate that firms increase investment by $0.38 for each dollar of proceeds received from the exercise of stock options, and that the sensitivity of investment to proceeds from option exercises is higher in firms likely to face financing constraints.
Number of Pages in PDF File: 45
Keywords: financial constraints, stock options, investmentworking papers series
Date posted: March 6, 2008 ; Last revised: March 22, 2009
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