Final answer:
An incentive contract, such as managerial stock options, aims to align executive interests with shareholder interests by providing the right to buy company stock at a set price. However, they can lead to excessive risk-taking and short-term focus, and may lose effectiveness if the stock price falls too low.
Step-by-step explanation:
An incentive contract is a type of agreement designed to motivate parties involved, typically by linking compensation to certain performance metrics. In the context of corporations, managerial stock options are a common incentive mechanism provided to executives and managers. These options give the individual the right, but not the obligation, to purchase company stock at a predetermined price after a specified period, aligning their interests with those of the shareholders by incentivizing them to increase the company's stock value.
However, there are limitations to this approach. Managerial stock options can lead to excessive risk-taking as managers may focus on short-term stock price increases at the expense of long-term company health. They may also encourage earnings manipulation to meet specific stock price targets. Moreover, if the stock price falls below the option exercise price (becoming 'underwater'), it may lose its incentive value altogether.
The effectiveness of managerial stock options as an incentive device depends on how well they align the interests of the management with the long-term goals of the company and its shareholders.