Academic journal article Academy of Strategic Management Journal

The Influences of the Chief Executive Officer's Stock and Option Ownership on Firm Risk Taking: An Examination of Resource Allocation Choices

Academic journal article Academy of Strategic Management Journal

The Influences of the Chief Executive Officer's Stock and Option Ownership on Firm Risk Taking: An Examination of Resource Allocation Choices

Article excerpt

ABSTRACT

We examine the influences of the chief executive officer's (CEO's) stock and option ownership on firm risk taking, proxied by resource allocations to research and development (R&D), discretionary funds, and advertising. We contend that at low to moderate values of managerial stock ownership, risk-increasing decisions may predominate. At substantial executive equity values, however, we suggest that risk-reducing decisions may be motivated. In contrast, our contention is that CEO option holding values are monotonically and directly associated with corporate risk taking. Additionally, we expect the joint effects of stock and options on firm risk may be different from their individual effects. The empirical findings are supportive of our contentions.

INTRODUCTION

Researchers have studied the influences on firm outcomes of ownership stakes. The implication of the related studies has often been that the effect on corporate outcomes of common stock is similar to options (e.g., Joseph & Richardson, 2002; Mehran, 1995; Shleifer & Vishny, 1997; Wright, Ferris, Sarin, & Awasthi, 1996). The influence of stock ownership, however, may be different from that of option holdings. That is because common stock ownership confronts executives with both downside and upside share price movements whereas option holdings ordinarily expose managers to solely upside price movements. Hence, options only expose managers to the upside outcome potential, whereas stock ownership exposes managers to both upside and downside outcome potentials.

Our contention is that the influence of common stock and option ownership on corporate risk taking may be similar or different, not only individually, but also in combination. We suggest that at low to moderate values of common stock ownership in the firms they manage, the effect of executive equity stakes is similar to options. Contrarily, we argue that at substantial values of stock ownership, managers may become overinvested in the firm and predisposed to negatively influence firm risk. In this setting, consequently, the impact of common stock may be opposite to that of option ownership. Additionally, where examined in combination, we find that options may nullify the negative influence of stock ownership on firm risk at substantial values of executive stock ownership.

The notion that executive equity ownership may have non-linear associations with corporate outcomes, however, has been recognized in prior studies. For example, Stulz (1988) and Shivdasani (1993) argued that the relationship of ownership structure of target firms with the value of takeover bids may initially be positive and then subsequently become negative with rising insider ownership stakes. McConnell and Servaes (1990) as well as Morck, Shleifer, and Vishny (1988) demonstrated a non-monotonic relation between firm value and ownership stakes of board members. Joseph and Richardson (2002) showed a non-monotonic association between ownership incentives of board members and resource allocation to advertising. Also relevant to our work, Wright, Ferris, Sarin, and Awasthi (1996) reported a non-linear association between executive ownership and firm risk, using the dispersion of earnings forecasts.

Our contributions in this study, however, differ from those made in the prior literature. Specifically, we focus on values of equity ownership (in isolation of option ownership) and executive preferences for changes in corporate risk as motives for select resources allocation decisions. Where managerial ownership stake values in the enterprise are low to moderate, we suggest that risk-increasing decisions may prevail since with such decisions the value of executive equity stakes may increase (Agrawal & Mandelker, 1987; Chang, 2003; Wruck, 1994; Wright, Kroll, Krug, & Pettus, 2007). In contrast, with substantial values of common stock in their enterprises, we expect that executives may prefer risk-reducing corporate strategies since they might perceive that such strategies could protect their private interests. …

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