Leverage and growth: Effect of stock options

Previous literature documents a negative relationship between leverage and firm growth. This paper finds that once the incentives provided by stock options are accounted for, leverage does not affect firm growth. The paper also finds that the sensitivity of CEOs’ wealth to stock price (i.e. option delta) instead of leverage has a negative relationship with growth. These findings suggest that incentive contracts that tie managers’ wealth to firm value prevent managers from overinvesting. Thus in presence of options the role of debt as a disciplining mechanism has become less important.

► This paper finds that the previously documented negative relationship between leverage and firm growth disappears when the incentives provided by stock options are accounted for. ► The paper also finds that the sensitivity of CEOs’ wealth to stock price (i.e. option delta) instead of leverage has a negative relationship with growth. ► While good governance firms rely on options to discipline managers, poorly governed firm use both leverage and options. ► These findings suggest that incentive contracts that tie managers’ wealth to firm value prevent managers from overinvesting.