Managerial Options

D

Managerial options refer to a set of contracts that grant managers the right, but not the obligation, to engage in specific actions that affect the firm's value. These options are often used to incentivize managers to make decisions that align with shareholder interests and to reduce agency risk.

Option A is correct. Managerial options can be used to reduce agency risk by aligning managers' incentives with shareholder interests. For example, stock options give managers the right to purchase company stock at a predetermined price. If the stock price increases, the manager can exercise the option and purchase shares at a lower price, resulting in a profit. This incentivizes the manager to make decisions that increase the stock price and aligns their interests with shareholders.

Option B is incorrect. Diversification is a strategy for reducing total firm risk, but it is not related to managerial options.

Option C is incorrect. Managerial options are not used to increase management compensation. Instead, they are used to align management incentives with shareholder interests.

Option D is partially correct. Managerial options can provide opportunities for altering management decisions in the future. For example, a manager with a call option on a new product may be more willing to invest in the product because they have the right to purchase shares at a lower price in the future. However, this is not the primary purpose of managerial options.

In summary, managerial options are methods for reducing agency risk through the use of incentives.