Unformatted text preview: ormances are proportional to the firm performance. But equity stock price is not the true
indicator of the firm value.
ESO encourages the managers and executives to look for short term goal. As the price of the stock
increases the net return from the ESO option, increases. Hence the executives try to take up more
risky projects with chances to gain higher return than and hence the net worth of their stock options.
But their down side risk is limited; the risk lies with the lenders. Thus the managers with high stock
options indulge themselves continuously into more risky projects and this may finally lead to the
bankruptcy of the firm. In this regard it’s worth mentioning that managers are affected by the
bankruptcy but they are not concerned with the volume of asset lost due to bankruptcy.
The executives have incentive not to pay dividends when they are holding large stock options. The
value of a dividend paying call option is lower than the value of a non dividend paying call option
for the same underlying stock. Again the incentive of the executives increase with the higher price
of ESO and normally the exercise prices are not adjusted for dividend. So managers have very less
incentive to pay out dividend. 5 | P a g e 3.2.1 Literature Review Academicians and researchers though started questioning the effectiveness and accuracy of the ESO
concept from much earlier (Cohen, Hall et al 1999), but it actually gained pace after the collapse of
large firms and the financial meltdown (Rebeiz 2009, Choe, Yin 2006).
Choe and Yin have identified six major criticisms against ESO in their paper 2 and they have
summed up the issues as –
1. The difficulty of accounting issues in general and of expensing options in particular
2. The opportunity cost of options for the granting firm higher than the value of options to
3. Giving extra incentives to executives to manipulate accounting information
4. Rewarding execu...
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This document was uploaded on 01/14/2014.
- Winter '14