How to use Stock and Stock Options for Interest Alignment: Managerial Investment Behavior and Portfolio Considerations

Abstract

This paper analyzes theoretically the effect of stock and stock options on the investment behavior of managers. Recent theoretical results state that stock options are an inefficient means of motivating managerial effort. But if the manager holds restricted stock and is allowed to invest his non-firm related wealth in the market portfolio and the riskless asset, he will pass up positive net present value projects since he cannot diversify the firm-specific risk. The paper analyzes if and how this investment incentive problem can be mitigated by issuing stock options. In case options are used alternatively to stock, we find that for every positive exercise price lower than a critical level, there exists a unique number of options to induce the desired investment behavior if the manager does not hold any stock. The relation between exercise price and number of options issued is positive. Though, if the manager holds both stock and options, options with low exercise prices can no longer mitigate the underinvestment problem. In contrast, for exercise prices sufficiently large to eliminate the underinvestment incentives and a given number of stock, there are a small and a large number of options to induce the desired investment behavior. Since recent theoretical contributions have called into question the efficiency of stock options in motivating managerial effort compared to restricted stock, this paper can make a contribution concerning the prevalence of stock options in executive compensation. A numerical analysis completes the paper and underlines the relevance of the theoretical results.