Warren Buffett, chairman and CEO of Berkshire Hathaway, Inc., is an outspoken critic of executive-stock option plans, at least as they are commonly employed. In a typical stock-option plan, top executives are given the right to buy company stock at the current price for a period of up to 10 years in length. Such options have obvious economic value given the 10 %+ long-run rate of return on common stocks. Nevertheless, the costs of executive stock-option-based compensation are typically not reflected in the company’s income statement.
A. Explain how the failure to include stock-option based compensation costs in the firm’s income statement could lead to a type of information asymmetry problem.
B. How could the potential for such a problem be avoided? In other words, how would you design an effective executive stock-option-based compensation plan?