Question

In recent years, top managers have been given large packages of options, giving them the right to buy stock in the firm at a fixed price. Will these compensation schemes make managers more responsive to stockholders? Why, or why not? Are lenders to the firm affected by these compensation schemes?

Answer 1

Management stock options create incentives for executives to manage firm in ways that maximize the market value since options increase the value with unpredictability of the underlying stock, management stock options provids managers with incentives to take actions that increases firm profitability.

Generally management respond to these incentives, there is a statistically significant relairelatio between increase in option holdings by the management and subsequent increase in firms wealth.

Such incentives for managers encourage them to take on risky projects that they might not have taken otherwise , because the value option increases with the variance of return of the underlying asset.