should be indifferent between them. When managers are
rewardedprimarilywithoptions,wealterthisbalance.Since
options are rendered more valuable by higher volatility,
managers will prefer higher-risk investments to safer
investments. While this may not be a problem if the net
presentvaluesontheinvestmentsarethesame,itcanbecome
a problem when the safer investmentwith the higher net
presentvalue isrejected in favor ofthe riskierinvestment
with a lower net present value. In effect, common
stockholders in these firms are subsidizing option-holding
managers. In practice, the bias toward higher risk can
manifest itself in many ways. For example:
- Cash versus real investments. Cash invested in
Treasury billsand commercial paperis a zero net
present value investment, but it is riskless. It is
possiblethatmanagerswillfeeltheurgetoinvestthe
cashin riskyrealprojects(oracquisitions),evenif
these projects have negative net present value. - Risk shifting. Overtime, managers maymove the
firmtowardriskierbusinessmixes,evenifitdoesnot
make economic sense. The loss in value may be
offset by the gains on option holdings for managers.
Theempiricalevidenceontheinterplaybetweentheexistence
ofmanagementoptionsandinvestmentpolicyismixed.Some
studiesseemtoindicatethatmanagerswhoarecompensated
withoptionsactuallytakelessriskbecausetheyhavesomuch
of their wealth tied to how well the firm is doing.
Financing Policy