Resolving the Agency Problems of External Capital through Options

Authors

  • ROBERT A. HAUGEN,

    Charles Albright Professor of FinanceSearch for more papers by this author
    • Charles Albright Professor of Finance, Graduate School of Business, University of Wisconsin Madison.
  • LEMMA W. SENBET

    Associate Professor of FinanceSearch for more papers by this author
    • Associate Professor of Finance, Graduate School of Business, University of Wisconsin-Madison. Currently visting at J. L. Kellogy Graduate School of Management, Northwestern University.

  • We wish to acknowledge helpful suggestions and comments on the earlier draft from Michael Brennan, Richard Green, Alan Kraus, Dennis Logue, Wayne Mikkelson, and especially Alvyn Stroyny, Dean Wichern, the participants in the Finance Workshops of the University of Wisconsin-Madison, York University, and Northwestern University. We have also benefited from conversations with Richard Roll on this issue.

ABSTRACT

This paper investigates the role of stock options in resolving the agency problems of external capital as originally identified by Jensen and Meckling (1976). These problems are precipitated by managerial incentives a) to consume excessive non-pecuniary benefits or perquisites beyond the optimal level for sole ownership and b) to engage in risk shifting in productive decisions so as to transfer wealth from external capital contributors. These incentive problems can be resolved through a strategy that judiciously combines call and put options retained by the owner-manager and external financiers, respectively. The resolution of the agency problems through this mechanism provides an economic rationale for the existence of managerial stock options and convertible debt.

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