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IAI Actuarial Core Principles · Business Finance · Key principles of finance

A company grants its senior managers share options exercisable in three years, to align their interests with shareholders. Which of the following is a recognised drawback of such a scheme?

Share options give managers upside gains without matching downside losses, so they may take excessive risk or focus on boosting the short-term share price, which can work against long-term shareholder interests.

  1. AIt removes all risk for managers because options cannot lose value
  2. BIt may encourage managers to take excessive risk or manipulate short-term share price, since options have limited downside for the holderCorrect
  3. CIt guarantees that managers will never leave the company
  4. DIt makes the company's cost of equity fall to zero
  5. It transfers all agency costs to the lenders

Explanation

Options pay off only if the share price rises above the exercise price, so holders gain from upside but do not bear the downside. This can encourage risk-taking or short-term price manipulation. The other statements are untrue or unrelated.

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