Executive Option Plans and Incentives to Take Risk in Levered Firms: Equity Value or Firm Value Maximisation?

Gerald T. Garvey and Amin Mawani

Chapter 8 in Banking, Capital Markets and Corporate Governance, 2001, pp 204-232 from Palgrave Macmillan

Abstract: Abstract Financial leverage does not distort investment decisions if executives are paid to maximise total firm value rather than equity value. Existing models of this idea imply that stock-based incentives should be negatively related to firm leverage, a prediction that has little empirical support. We show that the risk distortions induced by financial leverage can be overcome without diluting effort incentives by adjusting the exercise price of executive stock options. We also show that the necessary adjustments are similar to the common practice of granting options at-the-money. We then empirically examine the risk incentives of executive stock option plans in a large sample of Canadian firms. The evidence consistently supports the hypothesis that executive stock options mitigate the risk-taking incentives of shareholders in levered firms.

Keywords: Capital Structure; Stock Option; Strike Price; Incentive Contract; Exercise Price (search for similar items in EconPapers)
Date: 2001
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Persistent link: https://EconPapers.repec.org/RePEc:pal:palchp:978-0-230-28814-0_8

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DOI: 10.1057/9780230288140_8

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