An Examination Of The Effectiveness Of CEO Stock Option Granting Decisions Toward R&D Investments?

Abstract

Stock options are used to motivate investments in risky projects, such as R&D investments. When compensation committees make granting decisions to stimulate R&D spending, they should consider the following firm characteristics: (1) a firm’s growth opportunities; (2) a firm’s financial leverage; and (3) the CEO’s stock ownership prior to stock option grants. This paper addresses the effectiveness of CEO stock option granting decisions by examining whether compensation committees take these three factors into account. Using a recent sample over the period of 1992-2006, we find that firms with greater growth opportunities and firms in lower financial leverage are more likely to award CEO stock options to motivate R&D investment. These findings are consistent with that options are designed effectively to motivate managerial risk taking, thereby aligning the interests of managers with those of shareholders. However, contrary to our prediction, compensation committees tend to grant more to CEOs with larger stock ownership to induce R&D spending. A potential explanation for this finding is that CEOs with relatively large stock ownership affect the granting process and grant themselves with excessive stock options. Taken together, the evidence of CEO stock option granting process partially supports the notion that firms make effective stock option plans to mitigate incentive problems of risk-averse managers.