Question

A disadvantage of using stock options to compensate managers is that:________

A) it encourages managers to undertake projects that will increase stock price.
B) it encourages managers to engage in empire building.
C) it can create an incentive for managers to manipulate information to prop up a stock price temporarily, giving them a chance to cash out before the price returns to a level reflective of the firm's true prospects.
D) All of the above

Answer 1

C) it can create an incentive for managers to manipulate information to prop up a stock price temporarily, giving them a chance to cash out before the price returns to a level reflective of the firm's true prospects

Step-by-step explanation:

A disadvantage of using stock options to compensate managers is that it can create an incentive for managers to manipulate information to prop up a stock price temporarily, giving them a chance to cash out before the price returns to a level reflective of the firm's true prospects.

A stock option is a contractual agreement that gives a buyer (investor) the right but certainly not an obligation to buy or sell a stock at a specified price and date, depending on the options' form. Generally, in business finance there are basically two (2) types of options;

1. Puts: it is a bet that a stock will likely fall in the short or long run.

2. Calls: it involves betting that a stock will rise in the short run or long run.

Hence, if managers are compensated with a stock option it gives them the opportunity to cash out early.