Narrow Results

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 show that under- and over-investment problems can be large and economically significant, with hurdle rates ranging from more than 20 percentage points below to more than 35 percentage points above shareholders' required rate of return. Finally, firm value is not a strictly increasing function of a manager's incentive compensation or conventional pay–performance sensitivity metrics. Stronger managerial incentives to invest can benefit or harm a firm.