Timing for Dollars: How Option Exercisability Influences Resource Allocation

Stock options have been advocated to encourage managers to make long-run investments like R&D and capital expenditures (CAPX) that entail upfront costs with the potential to generate favorable long-term returns. However, the effect of options on managerial decisions depends on managerial beliefs about how the stock market reacts to firm behavior. If, consistent with empirical evidence, managers believe that stock prices increase in the short term from increased R&D, but not CAPX, then stock option exercisabilitywhich dictates when managers can receive option payoutsshould influence resource allocation. We also consider the effect of changes in the value of options over time. Results from a study of more than 6,500 observations from about 1,000 manufacturing firms over 18 years show that unexercisable stock options positively influence CAPX but not R&D, while exercisable stock options positively influence R&D but not CAPX. Both patterns are consistent with behavior that increases managerial payoffs but not necessarily firm performance. In addition, we find an expected negative association between underwater options and CAPX but no evidence of a corresponding positive relation with R&D. Finally, we find partial evidence of a house money effect that makes allocations to CAPX and R&D sensitive to recent changes in option values.