How much do CEOs gain from stock options when share prices change?

Transcription

1 How much do CEOs gain from stock options when share prices change? by Phillip J. McKnight and Cyril Tomkins University of Bath School of Management Working Paper Series

2 University of Bath School of Management Working Paper Series University of Bath School of Management Claverton Down Bath BA2 7AY United Kingdom Tel: Fax: Mark Hall and Cyril Tomkins A cost of quality analysis of a building project: towards a complete methodology Bruce A. Rayton The Residual Claim of Rank and File Employees Bruce A. Rayton Firm Performance and Compensation Structure: Performance Elasticities of Average Employee Compensation Stephen Brammer Endogenous Fixed Costs, Integer Effects and Corporate Performance Felicia Fai and Nicholas von Tunzelmann Scale and Scope in Technology: Large Firms 1930/ Areti Krepapa Market Orientation and Customer Satisfaction in the Service Dyad Areti Krepapa Interpreting to Learn: Theory and Propositions Felicia Fai and Nicholas von Tunzelmann Industry-specific Competencies and Converging Technological Systems: Evidence from Patents Phillip J. McKnight and Cyril Tomkins How much do CEOs gain from stock options when share prices change?

3 3 How much do CEOs gain from stock options when share prices change? Abstract The purpose of this study is to estimate the extent to which shareholder return influences changes in CEO option values. This study builds on prior research by employing two contrasting methods of valuing options, the Black and Scholes and the MSO option pricing models. Data was collected from the period 1992 to 1997 yielding a net sample of 131 UK publicly held firms. The magnitude of the sensitivities, as measured by the slope coefficients, were found to be much larger for the MSO as opposed to the Black-Scholes models suggesting that small increases in share price have an exponential effect on option valuations: a finding not captured by prior research. The MSO suggests, therefore, that the alignment of interests between the CEO and shareholder may be much closer than suggested by prior research in the sense that executives appear to gain considerably as share prices increase. However, given the scale by which executives gain, there is also an argument that executive and shareholder interests are not well aligned. Communications to be sent to Dr. Phil McKnight University of Wales, Cardiff Cardiff Business School Aberconway Building Colum Drive Cardiff, CF10 3EU Wales, UK Phone: mcknightpj@cardiff.ac.uk

4 4 How much do CEOs gain from stock options when share prices change? I. INTRODUCTION Issues surrounding executive share options began to emerge in the United States during the early 1980 s. A plethora of successful high-tech companies in Silicon Valley went public that year including Microsoft, Adobe Systems, Oracle, Silicon Graphics, and Sun Microsystems. With little cash to pay its key executives, the share option became the favorable compensation mechanism and before long these companies skyrocketed to astronomical valuations in turn creating instant multimillionaires. With media coverage intensifying, a critical report surfaced suggesting that before 1990 about 2,200 of Microsoft s 5,635 employees held options worth at least $1 million on paper (Lawlor, 1993). Today, share option compensation continues to receive widespread attention in both the UK and US. Executive share options currently account for more than 60 percent of a CEO s overall compensation package. 1 Not surprisingly, this explosive growth has brought about enormous criticisms from the popular press and has been partially responsible for triggering the publication of ethical guidelines such as the Greenbury Report (1995) which clarified standards for setting boardroom pay and calls for greater disclosure. 2 Some argue that the Greenbury Report has had little influence on the remuneration policies and practices of UK organizations in this respect. For example, Hewitt Associates, remuneration consultants, found over half 1 According to annual reports. 2 Greenbury (1995) report and Hample (1998) now comprise what is termed as The Code of Best Practice.

5 5 the British companies they surveyed were failing to comply with key recommendations of the Greenbury Committee (Times Business News, 1996). The attention executive share options have received over the years has triggered empirical research whose findings can be found in management, economic, finance, and accounting journals. The objective of these studies has been to place a value on these options via the Black-Scholes model and regress this against a firm s performance measure, such as shareholder return, to ascertain a β slope as a measure of the responsiveness of rewards from executive stock options to movements in the firms performance measures. With this measure of sensitivity, a higher β indicates a closer alignment of interest between the CEO and the shareholders. Some studies have gone a step further and attempted to quantify the velocity or speed at which wealth is being created for the corporate executive in accordance with the magnitude of β (Jensen and Murphy, 1990). These studies have been primarily of US origin and based on the initial works of Murphy (1985), and Jensen and Murphy (1990). 3 Empirical evidence provided by these studies has clearly demonstrated that the magnitude of the β coefficients is extremely small. In fact, the results of these studies have been referred to as disappointing (i.e. Jensen and Murphy, 1990), prompting researchers to conclude that the link between executive share options and shareholder return is notably weak, questioning the share option as an incentive alignment mechanism. Before making policy decisions based upon this research, it is important to examine closely the methodology used in this research and to inquire whether these studies have sufficiently documented the relationship between gains from executive share options and share prices. On just an intuitive basis, one might expect to find a

6 6 much larger β coefficient than discovered by these studies since an executive option is itself a non-tradable derivative of a firm s share price. Hence, the counter intuitive findings of this research warrants close examination. As for the method employed by these studies for valuing executive options, it has generally been the Black-Scholes model. Criticisms have been raised regarding its use and that it may well explain these poor relationships between the option values and share prices. ( See Noreen and Wolfson, 1981; Lambert and Larcker, 1985; Kerr and Bettis, 1987; Hill and Phan, 1991; Lambert, Larcker and Verrecchia, 1991; Foster, Koogler and Vickrey, 1993; Jennergren and Naslund, 1993; Kern and Kerr, 1997; Conyon and Murphy, 2000). It is possible that the use of the Black-Scholes model has been exceedingly influenced by the US accounting setting body, the Financial Accounting Standards Board (FASB). 4 The FASB has always maintained that options are not costless and the cost should be recognized when the options are issued by estimating the value of the option granted by the Black-Scholes method. Corporate executives have, however, argued strongly against the Black-Scholes method and attached greater importance to the intrinsic method for valuing the option. 5 Their reasoning is that if options are expensed according the Black-Scholes model, companies that used them extensively will see their reported earnings drop when the option is granted, ultimately affecting their firm s stock price. For example, in 1996, according to the Black-Scholes model, footnoted options expense for Microsoft was estimated at $570 million or 26 percent of profits. On the other hand, footnoted 3 In the UK, studies have investigated the pay-for-performance relationship by utilizing the aggregate of salary and bonus as the total pay construct. 4 Responsibility for setting accounting standards had transferred from the AICPA to the Financial Accounting Standards Board, an independent panel dominated by public accounting professionals. 5 This is an ongoing debate in the US (in the UK as well) between the FASB (Financial Accounting Standards Board) and the industry where for the moment the industry has won, by virtue of lobby pressure applied to congress by top executives such as Bernie Marcus Home Depot Chairman.

7 7 options expense with respect to an intrinsic value method would be zero assuming that the price on the date of grant is equal to the exercise price. Under the intrinsic method, the value of executive options would be related to the difference between the share price and exercise price at any time and the cost to the firm would be the increase in that value in each period. Setting aside accounting practitioner and business community views on the appropriate valuation model for reporting current costs of granting executive options, little has been written about the corporate preferred intrinsic value model. It will be shown in this paper, however, that an exploration of this noticeable gap in the literature may seriously change how we perceive the alignment of executive and shareholder interests - especially given the importance the literature places on the significance and magnitude of the β coefficient as described above. Consequently, the primary objective of this paper is to explore the extent to which the corporate preferred intrinsic option model provides a differing β coefficient to that of the Black- Scholes option model. Stated differently, our aim is to show how the perceived alignment of interests between executives and shareholders and the perceived velocity at which option related wealth is being created differs markedly according to which model is used. In doing this, we add to those who question the applicability of the Black-Scholes model as the methodological underpinning for this particular research topic. This paper will be structured as follows. Section II two presents theoretical arguments regarding both option pricing models. Section III outlines this study s methodology. Section IV presents the empirical results of this study. Finally, Section

8 8 V provides a discussion and conclusions reached from the findings as well as avenues for future research. II. THEORETICAL ARGUMENTS The primary motivation behind a share option is to reduce or, more optimistically, attempt to resolve the theoretical conflict of interest said to exist between the shareholder and executive (the principal and the agent). 6 With the shareholders primarily interested in share price returns, remuneration committees have utilized the share option because it more closely reflects any variation in share price. As a result, researchers investigations have focused on how changes in share price influence changes in executive share option values (Murphy, 1985; Jensen and Murphy, 1990; and Bizjak, 1993). As already stated, these studies have generally provided results with low ßs which have been considered disappointing in delineating the nature of this intuitive mechanical relationship. 7 Murphy s 1985 study was one of the earliest to explore this issue. What emerged from his regression was a rather small coefficient estimate of Murphy interpreted this to mean that executives receive on average a 2.5 percent increase in earnings for each 10 percent change in the value of the firm. Jensen and Murphy (1990), in a sequel to Murphy s 1985 study, attempted to convert the coefficient estimates into executive wealth terms. The authors calculated that for each $1,000 change in shareholder wealth, the typical executive would receive on average 14.5 cents. This was of course based on the coefficient estimate of.25 found by the earlier study by Murphy. Jensen and Murphy asserted that changes in executive share option 6 See Jensen and Meckling (1976) for a more in-depth explanation of agency theory.

9 9 valuations appeared to be less sensitive to shareholder return than previously thought. As a result, they concluded share options did not appear sufficiently rewarding to influence managerial behavior. As highlighted earlier, prior research has tended to rely on the Black-Scholes model in determining option valuations with respect to pay related compensation (Black and Scholes, 1973). It is quite clear that this model did provide a break-through in our understanding of how traded options derive value. There are limitations, however, with the model that raise questions as to whether it is the most appropriate option valuation model to be used in conducting investigations into the relationship between executive rewards and performance. 8 One major limitation with using Black-Scholes for this type of research is that the researchers themselves must estimate several of its parameters and the results can be very sensitive to the assumptions offered. The most discernible of these parameters are the expected dividend yield for the remaining life of the option, risk free rate, the future volatility of the option, and the time until the option s expiration. Another concern is that the Black-Scholes model was originally intended to determine whether option related securities were properly valued by the financial markets, but executive share options are non-tradable. Other limitations include the fact that share options, in most instances, are subject to surrender if an executive leaves the company prior to vesting. These criticisms have been mentioned throughout the literature (Noreen and Wolfson, 1981; Lambert and Larcker, 1985; Kerr and Bettis, 1987; Hill and Phan, 7 It should be noted that other studies have used the Black-Scholes model approach to measure the level of pay received from share options, but they do not consider the degree of sensitivity between changes in the variables in question (Matsunaga, 1995; and Mehran, 1995). 8 It is also stressed that the following comments addressing possible shortcomings of that model relate only to its use in the academic research process in relation to executive options. Comments here must not be taken as an attack on Black-Scholes as a general model for the economic valuation of tradable call and put options.

10 ; Lambert, Larcker and Verrecchia, 1991; Foster, Koogler and Vickrey, 1993; Jennergren and Naslund, 1993; Kern and Kerr, 1997; Conyon and Murphy, 2000). Recognizing these points, Kern and Kerr, (1997) argued that this debate on valuation will not be of significance to empirical research if the time series of Black-Scholes and intrinsic valuations are highly correlated. 9 This argument is very misleading. It is quite obvious that one can have two series of observations in a time series that are perfectly correlated, but which have quite different regression slopes. Moreover, as already stressed, with most executive pay research (i.e. Murphy, 1985; Jensen and Murphy, 1990) the prime purpose is to identify the slope (β coefficient). That is to identify the functional relationship that explains the extent to which the executive gains through holding executive options as the share price of his employing company changes. The limitations with the Black-Scholes model identified in previous literature all suggest that there is merit in examining differences obtained when using the intrinsic valuation model compared to the Black-Scholes model. The existing literature seems, however, to have missed another very important methodological factor that may explain why the use of the Black-Scholes model in prior research has yielded poorly correlated returns from executive options and company shares. To recognize this, one must be very clear about the purpose of these regressions. The purpose is not to show what the executive gains in terms of economic value at the time the option is granted. That would, indeed, be closely approximated by the Black-Scholes valuation that, in effect, shows the present value of the future gains that the executive is likely to realise. We agree that there is, as the FASB argues, as strong case for using Black- 9 Kern and Kerr calculated both Black-Scholes and intrinsic (heuristic) values and then dropped the latter because r = 0.7 for these two series. However, no information was provided about the β

11 11 Scholes in accounting reports to show the likely cost incurred by shareholders when executive options are granted. Such an argument must be distinguished, however, from the specification of the preferred research methodology to be used to determine the extent to which executives gain from holding option as share prices change. It is fundamental to recognize this difference because, to explore this relationship, care must be taken to match the gain from holding the option with the relevant increase in share price. Suppose that an executive is issued with options in year 1 in the expectation that this will influence him or her to greater exertion leading to increased profitability and increased share price. It is likely that time will be needed before the new effort of the executive becomes visible and the results feed through into an increased share price. Hence, this may lead to a share price increase in, say, year So, researchers using the Black-Scholes methodology (at least as used in the past), would show an executive gain from his options in year 1 when the option was granted, but the share price would increase in year 2. There would be a mismatch of the variables that have to be related to each other in the regression the increase in value of options held would be matched against this year s change in share price that, in the simple example just provided, would be zero. Given this time mismatching in regressing the gains from the executive option and the actual change in share price, it is not surprising that studies using this methodology have shown poor correlations between the two variables and suggest that the option had no influence in inducing greater executive effort. At the very least the use of the Black-Scholes model should involve some coefficient regarding the two models. 10 This would, of course, not be the case if the market received information on the award of all executive options and understood perfectly how the executive would respond and what impact that would have upon corporate profitability in future. Then the share price would adapt as soon as the

12 12 lagging of variables or, possibly, the measurement of changed shareholder return over a longer period, but it is quite unclear what lagging or length of period should be applied. It depends upon when the executive s increased effort, if indeed there is one, has an impact on share price and this must be highly context dependent. In contrast, while the intrinsic valuation model is probably not appropriate for accounting reports on the cost incurred by shareholders when options are issued, the increase in the intrinsic value of the option (related to the difference between the share price and the exercise price) will obviously be matched with the change in share price. The actual formulation of the value of the executive option makes ensures this. Of course, in regression analysis one must be wary when a factor, in this case share price, influences the measurement of both independent and dependent variables. It is then almost a truism that there will be a good correlation between variables on each side of the equation and one has learned nothing new about what influences what the regression was not needed to show that, it is discernible from the formulation of the option valuation. So, in this type of research, the point of running the regression is not to show whether there is a good correlation between the dependent and independent variables, which is, in fact, already known, but to show, given the corporate variation in practice of granting options, to what extent executives in the economy have, on average, gained through holding options when share prices have increased. It is legitimate to use a regression to discover the size of this average slope even if we know the independent and dependent variable are highly correlated. Indeed the slope of this functional relationship is of some interest as an average, even if its significance were low, but, of course, if the relationship is also statistically option was issued. But the very existence of this type of research that questions what effect executive options have suggests that such a perfect information flow and interpretation does not exist.

13 13 significant, one is in a better position to conclude that most executives holding options benefit to similar extent in relation to share price gains. Hence there is a strong case for employing the intrinsic model of executive options in research designed for this purpose. It is likely to give a better indication than the Black-Scholes model of the average gains made by executives as their own company s share price increases. III. METHODOLOGICAL CONSIDERATIONS Data and Sample Data is gathered from three principal sources. These are the company s annual report, Risk Measurement Service 11, and Financial Analysis Made Easy (FAME). The period under investigation is from 1992 to The sample consists of over 72 firms and is based on the following criteria: 1) the firm must be of UK origin, and 2) the firm must be publicly held. In all, the sample will represent at least eight major activity groups as measured by the 2-digit SIC code. 12 It should be noted that the company s annual report was most informative with respect to option specifics. However, where some firms reported only average weighted options, others elected not to report such details as option grant dates or grant price and, as a result, those firms were excluded from the sample. Finally, a regression analysis was utilized by this study and, as discussed at length above, we are particularly interested in both the level and direction of the β coefficient as a measure of the sensitivity of executive option values to share price changes. Jensen and Murphy (1990) assert that one can interpret the level of β as the degree of 11 This is a quarterly publication by London Business School. 12 The sample size is considered representative of firms in general and is similar to that of Jensen and Murphy (73).

14 14 alignment between the shareholder and executive s interest and that a higher level of β would indicate a closer alignment. Variable Measurements Although it has been argued that the intrinsic option valuation model is more appropriate for this type of research, both the MSO and the Black-Scholes option models will be employed for valuing executive share options. The opportunity was taken to run both models using the same data in order to check whether the Black- Scholes model again produced low ß coefficients and whether this was a contrast to the findings based upon the intrinsic model.. The MSO as the value of options held by the executive is defined as the difference between current share price and the exercise price subject to a valuation of zero where the share price is currently less than the exercise price. 13 On this basis, the MSO valuation model is estimated as follows: where: j V jit = j N jit (P t - G j ) + + E jit (P e t - G j )+ (1) j 1) V is the sum of the minimum value of all options issued in tranches j held by executive i at the end of or exercised within period t, 2) Njit represents the total number of options held by executive i at the end of year t, 3) Ejit is the number of options exercised by executive i during year t, 4) Pt is the share price related to the share options at the end of year t, 13 We feel that the value of zero where the share price is below the exercise price is justified because executive options are not traded, and we are trying to establish realizable executive income in each year. Moreover, our intent is to show the extent to which model produces a more robust measure of sensitivity.

15 15 5) P e t is the share price on the date of exercise in year t, 6) G is the grant price of the options, and 7) (P - G) + = max (P - G, 0). Although most other studies assumed that options were always exercised at the highest stock price observed during the year, this study used data on actual exercise prices obtained from annual reports, a technique which should produce a more accurate valuation measure. The Black-Scholes option formula has been employed by numerous research studies for valuing executive share options (Merton, 1973). In this study, the model has been modified to recognize those options that have been exercised as well. As discussed in the aforementioned paragraph, this study used data on actual exercise prices obtained from annual reports. The Black-Scholes is estimated as follows: Options Value = Ν t [Pe dt Φ(Ζ) Χe r F T Φ(Ζ σ T )] + Ε t (P Χ), (2) where: 1) Φ is the cumulative standard normal distribution function, 2) Ν is the number of share options held, 3) Ε is the number of share options exercised, 4) P is the share price as of the year end, 5) P is the share price on date of exercise, 6) Χ is the exercise price, 7) Τ is the time to expiration, 8) r F is the risk free rate, 9) d is the expected dividend yield for the remaining life of the option, 10) σ is the expected stock return volatility over remaining life of the option, 11) Ζ = [ln (P/Χ)+ T(rF-d+σ2 /2)]/σ T, and 12) Ε t (P Χ) denotes those options which were exercised during the period. Finally, shareholder return (SRit) is the share price return realized by the shareholders. Shareholder return is defined as:

16 16 SR it = [(ln(sr it +d it ) ln(sr it-1 )], (4) where ln is the natural logarithm of SR it the closing year share price for firm i in period t plus d it the dividends paid by firm i in the year t minus SR it-1 the natural logarithm of the closing year share price for firm i in period t All dividends are calculated on a continuously reinvested basis. Modeling We estimate the following equation to test the extent to which shareholder return influences the change in option-related pay: (CEO option values) it = α t + β(sr) it + e it (5) Model (1) predicts that the left hand side variable, CEO option values it, will be affected by SR it, the right hand side variable, over time for executive i in time t. Where CEO option values it is the change in the natural logarithm of executive share options for both the MSO and Black-Scholes models, the vector SR it represents shareholder return for company i in the period t. A practical problem occurs in deciding, with the intrinsic model, how to deal with zero valued options in the regressions,. They can be omitted from the regressions, but it was felt that this would be misleading. The alternative is to give them a small positive value. The problem is then what value and whether the value assigned materially affects the resultant ß coefficient. We know of no theoretical basis for deciding this issue. Our analysis is based upon applying a value of 100 to zero valued 14 Stated differently, the rate of return is ln[(spt + dt)/spt-1].

17 17 options, but Table 1 shows how the coefficient changed when positive values of 1 to 10,000 were used. The coefficients obtained are quite sensitive to this decision, and the eventual comparison of results with those using the Black-Scholes model should take this into account 15. <Insert Table 1> IV. RESULTS Regression estimates for the change in executive share options and shareholder return appear in Table 2. As expected, the MSO and Black-Scholes models have both positive and statistically significant signs. However, the magnitudes of the β coefficients are markedly different. Where the MSO model provided a slope of 5.3, the Black-Scholes model suggested a slope of only 1.5. This seems to be in accordance with our argument about methodology. <Insert Table 2> As for the MSO, applying Murphy s (1985) interpretation of regressions based on natural logarithms, a 10 percent increase in firm value will translate into a 53 percent increase in the value of an executive s share options. Conversely, the Black-Scholes 15 In their study, Kern and Kerr (1997) found that the Black-Scholes based option valuations and the intrinsic based valuations were highly correlated (R =.70). Using a 100 option floor for intrinsic valuations, we arrived at a similar correlation (.69). Although the argument is tenuous, we used that as a criterion to use the 100 base. As one would expect, it was found that as the positive number selected was increased, the natural log of that number amplified as well. In contrast, this appeared to have an inverse affect on the β coefficient in which the slope tended to decrease the further the floor departed from zero. It may well be more correct to use a 1 base as being closest to zero in which case,as shown in Table 1, the ß coefficient for the intrinsic valuation would be higher than than that used in the discussion of the results.

18 18 model suggested the sensitivity between share options and share price is considerable less; that is, a 10 percent increase in firm valuation translates into a 15 percent increase in share option valuation. An engaging question is what do these coefficient estimates translate into in pound ( ) terms? Assuming a coefficient of 5.3, for the MSO, and a median 1997 market capitalization of 2.5 billion, the value of an executive s share options would grow by an average of 1.46 for each 1,000 increase in firm value. 16 On the other hand, a 1.5 coefficient estimate for Black-Scholes calculations suggests option valuations would increase by 41 pence per each 1,000 rise in firm value. These values differ considerable from those found by Jensen and Murphy; that is, about.09 pence per each 1,000 firm value increase. 17 Overall, the MSO model provides markedly different slope coefficients than that provided by the Black-Scholes model, suggesting that the financial interest of the executive and the shareholder is more closely aligned than previously thought. Moreover, the wealth multiplier as denoted by β suggest the velocity at which wealth is being created for the executive is considerably higher for the MSO (5.3) 18 as opposed for the Black-Scholes (1.5) model. To provide more insight into why perhaps the Black-Scholes and MSO coefficients exhibit such huge extremes in leverage, we examine Figures 1. Panel A in Table 3 finds that ending period option valuations for the Black-Scholes are 90,225 as opposed to zero for the MSO model. This is particularly interesting when considering that the share price ( 2.30) remained equivalent to the exercise price 16 The computations for the MSO were [5.3 (1000 * (686,961/2,500,000,000))] to arrive at A.60 currency rate was applied in converting 14.5 cents to.09 pence as found by Jensen and Murphy s study. 18 It is as high as 7.8 if the zero valued options are assigned a value of 1 in the regressions and even with a value of 10,000 assigned the coefficient is still 3.5 and well above that for the Black -Scholes model.

19 19 ( 2.30) during this period. Furthermore, a similar situation was encountered under panel B where ending option valuations for the Black-Scholes (192,660) were some 38 percent higher than those of the MSO (140,000) model. A striking feature of Table 3 is the percentage changes in beginning and ending values for both option models in comparison to the firm s share price. For example, panel A suggests option valuations decrease 36 percent under the Black-Scholes model compared to a zero percent change for the MSO. This result takes on greater significance when compared to a zero percent change in shareholder value for the respective period. As for Panel B, it perhaps provides more insight into just how sensitive the two models are with respect to share price movements. A 20 percent change in share price triggers a 250 percent increase in MSO option valuations. This is noticeably different from that found by the Black-Scholes (14.6 percent) model. <Insert Table 3> V. DISCUSSION AND CONCLUSIONS Agency theory asserts that to a large extent policies regarding compensation should link the agent s interest to that of the principal s. Since the interest of the principal is to maximize shareholder wealth, then according to agency theory, CEO pay policies should be dependent on shareholder return, as measured by changes in share price. Our empirical evidence is consistent with this notion in that the value of the CEO s options are both positive and significantly related to shareholder return. Although the estimated pay and performance sensitivity is both positive and statistically significant whichever valuation model is used, the magnitude of these

20 20 coefficients between the Black-Scholes and MSO models is markedly different. According to the MSO, a slight movement in share price appears to have a large leverage affect on option valuations, a finding that the Black-Scholes model does not fully capture. More importantly, the degree of leverage as denoted by β suggests there is a much closer alignment of interests between executive and shareholder. These findings contradict prior research that maintains that industry is failing in its attempt to properly align the interest of both parties (Jensen and Murphy, 1990). On the other hand, based on the MSO coefficients, some might argue that executives are gaining too much from share price increases and that shareholder and executive interests are misaligned after all not because there is little correlation between executive and shareholder return, but because executives seem to have levered very significant option gains from share price increases. Although the empirical evidence from this study may suggest the interests of the executive and shareholder is aligned more closely than previously thought, it tells us very little about the incentive effects of share options on human motivation. One fruitful avenue of future research is to explore whether executives are actually motivated by these options and whether it is their effort that leads to the share price increases observed. An alternative explanation is that it is just the general bull market that is responsible for driving these (abnormally high) security returns and executives are ensuring that they get their share by influencing remuneration committees to award them options. A key to unlocking this complex issue is to examine the way in which executives perceive themselves to be motivated by the share option itself. We have commenced case study work in three large publicly held multinationals

21 21 investigating this issue. 19 While we have yet to report on the results formally, it has been found, in general, that an executive s perception of gains from holding options are complex and incorporate a strong psychological factor. At no time during those interviews underlying this work did executives express views that suggested the Black-Scholes model (based on historic parameters) was the best approximation of their own conception of gains from holding options. Most executives had no understanding of how to value options with respect to the Black-Scholes model., but, more importantly, they do not seem to employ Black-Scholes notions even on an intuitive basis. Value was generally perceived (as with the MSO intrinsic model) according to whether or not the option was in- or out-of-the-money and, where they claimed motivation by the award of options, they saw their task to get these options in-the-money as soon as possible. 19 These firms have an average turnover of 15 billion a year with two of UK origin and the other of US origin. In total, 50 executives have been interviewed ranging from the CEO, executive and nonexecutive directors, to the group and divisional level executives.

22 22 REFERENCES Black,Fischer and Myron Scholes (1973).The pricing of options and corporate liabilities. Journal of Political Economy, vol. 81, pp Bassett,Philip.The Greenbury proposals snubbed. The Times Business News, April, Bizjak,J.,J.Brickley,and J. Coles (1993). Stock-based incentive compensation and investment behavior. Journal of Accounting & Economics, vol. 16, pp Conyon, M.J. and K. Murphy (2000). The Prince and the pauper? CEO pay in the United States and United Kingdom. Economic Journal, vol. 110 (November), pp Foster, T., P. Koogler, and D. Vickrey (1993). Valuation of executive stock options and the FASB proposal: An extension. Accounting Review, vol. 68, pp Greenbury, Sir Richard (1995). Directors remuneration. Report of a study group chaired by Sir Richard Greenbury. London: Gee Publishing Ltd. Gomez-Mejia, L., Tosi, H. And Hinkin, T. (1987). Managerial control, performance, and executive compensation. Academy of Management Journal, vol. 30, pp Hill, C. and Phan, P. (1991). CEO tenure as a determinant of CEO pay. Academy of Management Journal, vol. 34, pp Jennergren, L. and B. Naslund (1993). A comment on "Valuation of executive stock options and the FASB proposal. Accounting Review, vol. 68, pp Jensen, M. and Meckling, W. (1976). Theory of the firm: Managerial behaviour, agency costs, and ownership structure. Journal of Financial Economics, vol. 3, pp Jensen, Michael. and Murphy, Kevin (1990). Performance pay and top management incentives. Journal of Political Economy, vol. 98, pp Kerr, Jeffrey and Richard Bettis (1987). Boards of directors, top management compensation, and shareholder returns. Academy of Management Journal, vol. 30, pp Kern, Leslie and Jeffery Kerr (1997). The effects of outside directors and board shareholdings on the relation between chief executive compensation and firm performance. Accounting & Business Research, vol. 27, pp Lambert, R., D. Larcker, and R. Sherwin (1985). Golden parachutes, executive decision-making, and shareholder wealth/comment. Journal of Accounting and Economics, vol. 7, pp

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24 24 Table 1 The implications of option floors on the slope coefficients Option Floor ln of option floor Coefficient estimate ,000 10,000 0 based options deleted from sample

25 25 Table 2 Sensitivity Estimates for Stock Based Compensation and Shareholder Return: 1992 to 1997 Dependent Variables (change in ln) Independent Variables MSO Black-Scholes Constant -.08 (-.44).09 (2.5) Shareholder return Observations 5.34 (8.0)* (10.6)* 131 R 2 (.42) (.47) Notes Regression estimates represented first by the slope coefficient followed by the t-statistics in parentheses * Significant at level

26 26 Table 3 Black-Scholes versus MSO Panel A Panel B Share Price BS a estimate MSO estimate Share Price BS a estimate MSO estimate Beg. period , ,100 40,000 End. period , , ,000 Change in value 0-50, , ,000 % change in value % % 14.6% 250.0% a Black-Scholes parameter estimates are as follows: Beg. period End. period Risk-free rate 7.0% same Share price volatility 30.0% Dividend yield 2.5% Time to expiration (yr.) 5 2 Number of shares exercisable 200,000 same Exercise price 2.30