Do Stock Options Always Align Manager and Shareholders’ Interests? An Alternative Perspective

Shareholders want managers to invest in all positive net present value (NPV) projects, and to avoid those with negative NPV. Using a simple model of firm value, we explain why stock op-tions—when issued by firms with high price-to-book value ratios—do not always provide the incentive for managers to pursue these value-maximizing policies. This is noteworthy because option usage in the late 1990s was concentrated in the sort of firm—those with high P/B rati-os—in which they can be least effective. Our model gives students the opportunity to integrate and apply concepts from stock valuation and capital budgeting, and to think critically about the relative merits of stock options and restricted stock as forms of incentive compensation