Stock options and managerial incentives to invest

Tom Nohel and Steven Todd
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Tom Nohel: Loyola University Chicago

No 149, Royal Economic Society Annual Conference 2002 from Royal Economic Society

Abstract: We examine the effect of stock options on managerial incentives to invest. Our chief innovation is a model wherein firm value and executive decisions are endogenous. Numerical solutions to our model show that managerial incentives to invest are multi-dimensional and highly sensitive to option strike prices, the manager's wealth, degree of diversification, risk aversion, and career concerns. We find that over-investment problems are far more likely and far more severe that many researchers suggest. Finally, firm value is not a strictly increasing function of a manager's incentive compensation or conventional pay-for-performance metrics. Stronger managerial incentives to invest can benefit or harm a firm. Our results should send a cautionary signal to researchers who study managerial behavior. It is not sufficient to rely on one-dimensional risk-neutral valuation metrics, such as pay-for-performance, to describe the degree of incentive alignment between managers and shareholders.

Date: 2002-08-29
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