Capital Budgeting and Stock Option Plans

Stock option plans are derived as the optimal managerial compensation scheme based on the interactions between motivating the CEO to extract information on the profitability of investment projects and balancing her incentives for their acceptance or rejection. However, when profitability is on average either too high or too low, and its dispersion across projects is low, investors can benefit from awarding less powered incentive schemes. Our results suggest a non-monotonic relationship between Tobin's Q and the award of stock options. They also indicate that optimal managerial compensation generally leads to either under or overinvestment.

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