Abstract
Using a simple three-period model in which a manager can gather information before making an investment decision, this paper studies incentive effects of various executive stock options. In particular, we show how the exercise price of executive stock options is related to base salary, the size of option grant, leverage, and the riskiness of desired investment policy. The optimal executive price increases in the size of grant and base salary, and decreases in leverage and the riskiness of desired investment policy. Other things equal, the optimal exercise price of European options with longer maturity should increase more for an increase in base salary and the size of the grant, and decrease more for an increase in leverage than the one with shorter maturity. The optimal exercise price of American options is determined completely by the optimal exercise prices of European options with two different maturities. Given the fixed exercise price, the size of option grant does not decrease in the face value of debt.
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