Option compensation, dynamic investment and capital structure

Abstract

We develop a dynamic trade-off model of managerial discretion to investigate how stock option compensation relates to managers' intertwined capital structure and dynamic investment decisions. Our model predicts that option grants provide managers with incentives to undertake both current and future investments, in sharp contrast to the effects of stock compensation. With an increase in option compensation, managers in low- (high-) risk firms tend to increase (decrease) firm leverage, while the opposite is true when stock pay increases. This result offers an innovative prospective on the empirical tests of the relationship between option compensation and capital structure.