Question

What are the costs and benefits associated with compensating executives with stock or the option to purchase stock?

Answer 1

Benefits : -

1)Stock options align management’s interests with those of the shareholders by making management owners as well. By paying executives in stock options, executives receive a direct and personal financial incentive to better the company’s performance. Executives also have a disincentive to mess up, because if share prices prices drop as a result of bad performance, executives lose lucrative options. Aside from their salary, bonus and other benefits, executives can cash in hundreds of thousands of dollars or more if their hard work results in higher share prices.

2)Stock options are a cheap way to give executives lucrative benefits. When the company issues stock options, they must expense it as compensation. However, while that expense shows up as a cost in a profit report, the option requires considerably little cash on the company’s part. This makes stock options particularly attractive to companies that want to invest as much of their cash as possible into capital improvements, acquisitions and other things that grow the company.

Costs :-

1)The main disadvantage of stock options is that they dilute the profit per share of existing shares and the ownership of outside shareholders. Dilution frustrates existing shareholders and drives down the price of individual shares.

2)Executives receiving a large portion of their compensation in stock options take more extravagant risks, the majority of which go badly. Executives do not lose money when projects fare poorly because an option is not worth anything until used. However, when projects go well, executives cash in on their options and reap the benefits.