Some firms provide stock options to managers as an incentive to work hard and increase the value of the firm. A typical option contract gives the manager the right to buy the firm's stock at a set price (known as the exercise price). If the firm's stock value increases and moves above the exercise price, then the manager's option becomes more valuable. What is the potential problem with this incentive scheme?
A) The incentive does not include a performance benchmark, so it cannot be optimal.
B) There is a dynamic incentive problem-the manager may focus too much on the firm's short-run stock value and not on actions that are in the best interest of the firm for the long run.
C) The incentive value depends on the firm's stock value, which cannot be influenced by the amount of work or effort exerted by the manager.
D) There are no problems with this incentive scheme.

Question

Quizplus · Accepted Answer

The potential problem with this incentive scheme is that there is a dynamic incentive problem where the manager may focus too much on the firm's short-run stock value and not on actions that are in the best interest of the firm for the long run. This may result in the manager taking risky actions or engaging in short-termism that can harm the firm's long-term value. Therefore, option contracts may not always lead to optimal incentives for managers.

Some Firms Provide Stock Options to Managers as an Incentive