Abstract
We analyze the relative advantage of option grants compared to stock compensation when shareholders are diversified. Our analysis recognizes a conflict that is largely neglected in the corporate finance literature. Shareholders want to maximize their portfolio value while capital budgeting rules direct managers to choose projects that maximize firm (equity) value. Options can reduce this conflict by motivating managers to avoid projects that enhance the value of one firm at the expense of another firm. The analysis is performed in a competitive environment, where the compensation package of each manager is set separately. Consistent with the predictions of our model we find that firms with lower insider ownership, higher institutional ownership, and lower leverage tend to provide more option grants as compensation to their executives.
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