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Stock Options and Managerial Incentives to Invest
Tom Nohel Loyola University of Chicago Steven K. Todd Loyola University of Chicago November 9, 2001 EFMA 2002 London Meetings Abstract: We examine the effect of stock options on managerial incentives to invest. Our chief innovation is a model wherein firm value and executive decisions are endogenous. Numerical solutions to our model show that managerial incentives to invest are multi-dimensional and highly sensitive to option strike prices, the manager's wealth, degree of diversification, risk aversion, and career concerns. We find that over-investment problems are far more likely and far more severe than many researchers suggest. Finally, firm value is not a strictly increasing function of a manager's incentive compensation or conventional pay-for-performance metrics. Stronger managerial incentives to invest can benefit or harm a firm. Our results should send a cautionary signal to researchers who study managerial behavior. It is not sufficient to rely on one-dimensional risk-neutral valuation metrics, such as pay-for-performance, to describe the degree of incentive alignment between managers and shareholders.
JEL Classifications: G31, G32, G34, J33, M40, M46 Working Paper SeriesDate posted: August 07, 2001 ; Last revised: May 09, 2002Suggested CitationContact Information
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