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Beginning of stock option-based compensation in Japan : a test of alternative theories.

Abstract

Japanese companies are increasingly adopting stock option based compensation for executives and employees as a part of their efforts to regain profitability and capital market orientation after the burst of bubble economy. To analyze the economic justifications of option grants in Japanese companies, we use the framework of three different theories i.e., agency theory, retention and sorting model, and the financial and ownership structure of a firm. We use a cross sectional data of 12,896 firm-year observations of 1,612 listed companies of Tokyo Stock Exchange from the year 1997 to 2004. While, the agency theory fairly succeeds in defining the executive stock options, the employees' stock options are most consistent with the explanation of the retention and sorting motives. Determinants of the financial and ownership structure show mix results.

Key Words: Stock options; Retention and sorting; Agency theory; Japan

JEL Classification: C52, G14, G34, G53, 057

Introduction

In 1997, amendments in the commercial code of Japan made it possible for companies to use stock options as compensation for executives and employees. Further amendments in November, 2001 eliminated the ceiling on the percentage of outstanding stocks that can be offered as stock options as well as limitations on who can receive stock options, making it easier to use the companies' shares as a compensation package. Restructurings of the traditional corporate governance model and lifetime employment system that started after the burst of the bubble economy, helped stock options to have roots in Japanese companies *. Consequently, companies increasingly adopted stock options as a performance-based compensation system to gain a capital market orientation and ensure a commitment to the shareholders. The increasing use of stock options as a part of compensation in Japan, presents a challenge to the economists, interested in the Japanese employment relations. However, there are only few studies dealing with the economic significance of the option-based compensation for executives and employees in the Japanese business environment **.

Prelude

Most of the previous literature explains the use of stock options as a tool to mitigate the agency problems based on the assumption that stock options can provide incentive for the managers to act in the best interest of shareholders (e.g., Jensen and Meckling (5); Demsetz and Lehn (6); Jensen (7)). The use of stock options for the retention and sorting of potential employees, is also getting attention in the recent literature (e.g., Lazear (8)). The financial and ownership structure of a firm may also have a role in defining the decision to go for this type of compensation schemes (Lewellen, et al., (9); Clinch (10); Beatty and Zajac (11); Anderson, et al., (12)). However, due to the variety of implications associated with the stock options, a comprehensive analysis of the motives and determinants of stock options is still lacking. We use agency theory, retention and sorting model, and the financial and ownership structure of a firm to explain different aspects of stock options with reference to the Japanese business environment. By doing so, we are able to determine the difference in the motives of employee stock options and executive stock options, and redefine the role of risk and cash flow constraints in the decision to go for option-based compensation.

According to the agency theory, the use of stock options can provide an alternative mechanism of controlling when direct monitoring is difficult (Holmstrom) (13); Jenson and Murphy (14)). Thus, the complexity in monitoring the large and diversified firms may lead towards the use of stock options. Similarly, theoretical models suggest the use of option grants to provide an incentive when the unobservable managerial efforts have a greater effect on the firm's value (Milgrom and Roberts (15); Gaver and Gaver (16); Guay (17); Himmelberg, et al., (18)). Following these arguments, we explain the use of stock options when the set of growth options is larger for the firms. However, agency theory may hold better for the top executives that are actually involved in the decision making process, but may not hold completely for the lower level employees that can have a little direct impact on the firm's value. Agency theory can partially support the employee stock options with the justification that employees may feel peer pressure and mutual monitoring that can increase the collective efforts to enhance the value of a firm (Kandel and Lazear (19)). However, this leads to the prediction that there must be some additional explanation for employee stock options.

In this regard, the retention and sorting of employees are two potential benefits of stock options that are increasingly gaining interest in the literature. Stock options can motivate employees to remain with the firm because employees in general are required to exercise their options before they leave the company (Hale (20)). Retention of potential employees is of great interest in the Japanese business environment where the traditional LTE system is in a state of flux ***. Consequently, companies in Japan may adopt stock options as a retention mechanism to save their investments in the specific human capital. Retention of the key employees is critical when the human capital has a greater role for the value creation or when the firm has considerable growth opportunities related to the employees. According to Oyer and Schaefer (22) the firms having close competition for the same set of workers arc more concerned about losing their potential employees to the competitors. Therefore, such firms are likely to use stock options for the retention purpose.

The grant of options also adds a degree of risk in the compensation by tying the worth of payment with the value of a firm. An increase in the risk can reduce the incentive level of equity-based compensation because of the inability of managers and employees to hedge this risk (Aggarwal and Samwick (23); Jin (24)). This may lead to a lower use of option-based compensation when risk level is high. On the other hand, a higher risk increases the chances of attracting the less risk-averse and optimistic employees to work at the firm. Thus, the motives of sorting and attraction of optimistic employees support a greater use of stock options when the risk level is high. Similarly, when there is a greater variance in the potential employees' believes about the future returns of the firm, the option-based compensation will be more attractive for the optimistic employees or for the employees having the abilities and skill to increase the value of a firm. Therefore, in such cases, the use of stock options can help to attract the most suitable employees to work at the firm.

Previous literature explains the use of stock options to overcome the cash flow constraints (Leweilen, et al.; Clinch; Core and Guay (25); Anderson, et al.). On the contrary, the cost of issuing stock options for the company can be higher than its value perceived by the employees and managers ****. Thus, the use of stock options as a substitute of cash payment may involve some justification other than just cash flow constraints.

The alternative logic is explainable with the help of sorting motives of using stock options. A company can get the advantage of using stock options instead of cash payment, when it is able to attract the optimistic employees who can value the options greater than the market value. Thus, the substitute use of stock options is better explainable with the help of sorting considerations.

The interest and capability of ownership structure to monitor the firm, can also define the decision to go for option-based compensation. The presence of big shareholders can provide an alternative mean of monitoring the firm. Thus, a concentration of ownership may reduce the use of stock options. However, the institutional owners are likely to favor the market-based information to monitor the firm's performance and thus prefer to use stock options. This analysis contributes to the research literature in several ways

* First, it explores the issue, largely ignored in the research literature that why firms use stock options for employees when agency theory is not able to explain it completely. We use the retention and sorting motives to explain this form of compensation for employees. In this way, the findings are able to explain the difference in the determinants of the employee stock options and the executive stock options.

* Second, it addresses the controversies in the research literature about the role of risk and cash flow constraints in defining the use of stock options. We redefine the role of risk and cash flow constraints with the help of sorting model.

* Third, the findings of this analysis have important implications for the Japanese companies. The unique characteristics of the Japanese business environment and requirements of companies after the burst of bubble economy can help to explain the use of stock options for a variety of motives and expectations. These explanations can add new insights about the potential benefits and determinants of stock options.

Stock options in Japan

Stock options were banned in Japan before 1997 and compensation system was mainly based on cash salaries and bonuses. Historically, the managerial equity ownership in Japanese companies was also lower than their US counterparts *****. With a lower level of equity ownership the incentive to maximize the share price had been weaker in this system. While US system emphasizes the share price maximization, the Japanese system focuses the revenue and market share maximization.

Traditionally, the keiretsu relationship, cross shareholdings and main bank played major role in the Japanese corporate governance structure. Unlike in the USA, the board of directors in Japan consists of inside directors from within the company. Thus, the Japanese corporate governance system had been more inclined towards insiders (employees and management) than the outsiders (shareholders and stakeholders). This system worked successfully during fast growth and expansion of Japanese economy and companies were able to keep a balance between the insiders and outsiders.

However, the economic slump in early 1990s, highlighted the need of a link between the managerial compensation and shareholders' wealth. An efficient way of doing so appears to be in the form of stock option based compensation. But, Japanese law did not permit the use of stock options at that time. This was because of two rules in the article 210 and 280 of Japanese commercial code. First, companies could not hold their own shares except under unusual circumstances. This means companies could not have shares available for the grant of options. Second, companies have to designate the date of issue for any new shares, which was not possible for stock options with unidentifiable exercise dates. Nevertheless, the slowdown in economy, prolonged deflation and decreasing role of main bank elevated the pressure of shareholders for an open corporate governance system. Under these circumstances, the Japanese government amended the commercial code of Japan in 1997, which make it possible for the companies to award stock options to their executives and employees. These amendments provided two ways of issuing stock options. First, the company may repurchase its own shares to offer them as stock options. Second, the company may grant employees the rights of acquiring the new shares.

For the grants of options, it is mandatory to get a special approval by the General meeting of the shareholders. To get such approval, the firm needs to disclose information about the beneficiary of stock options, exercise price, strike price and exercise period. Accounting rules in Japan categorize the grant of stock options as capital transactions. Stock option granting firms are not required to expanse the value of options at the time of grants. Companies record these transactions as an increase in the capital at the exercise date. While the option grants are treated as capital transactions, the taxation rules provide no deduction in tax for the granting firms either at the date of grant or exercise. On the other hand, option holders of 'tax-qualified stock options' ****** are able to get some tax incentives. These option holders are not taxed at the date of grants. They are taxed only on the capital gains at the date of selling the stocks purchased through option grants.

While the accounting and taxation rules of stock options may be different in Japan and US, the underlying reasons of using this form of compensation can be similar. This paper is focused on analyzing the motives and expectations of Japanese firms in granting stock options as an effort to restructure the corporate governance without losing the core benefits of traditional system.

Methodology Used

According to the economist model of human behavior the executive compensation implicitly or explicitly requires that executives should have equity incentives to perform optimally (Jensen and Meckling; Demsetz and Lehn (31)). However, for non executive employees, it is less clear whether firms use stock options for incentive purposes (Core and Guay (32)). This is because; lower level employees can have comparatively smaller influence on the stock price by their individual actions. On the other hand, the option grants add a degree of risk in the compensation by tying the worth of payment with the value of a firm. To counterbalance this risk, there must be some economic justifications to use this form of payment for an optimal employment contract.

This paper considers the potential economic justifications to explain the use of stock options as compensation. It focuses on three different theories to explain the rationale of increasing use of stock options in the Japanese companies.

* First, according to the agency theory, the option-based compensation can provide an alternative monitoring mechanism and an incentive for better firm performance by aligning the interests of management with that of shareholders.

* Second, according to the retention and sorting model, the vested exercise period associated with the option grants can help to retain the talented employees in the absence of traditional LTE system.

In addition, the risk associated with the stock options can help to attract appropriate type of employees, such as less risk averse employees or the employees having abilities and skills to increase the firm value. Third, the ownership and capital structure of the company may also have implications to go for stock options rather than cash compensation.

It is important to note that these three theories are not mutually exclusive as they ultimately lead towards the greater symmetry between the interests and requirements of the owners and management/employees. However, the implications of these theories can be different depending upon the requirements of the companies. We try to calibrate these theories according to the Japanese business environment and provide the implications of each for the Japanese companies. These aspects are presented in detail as follows.

Agency Theory

Agency theory suggests that it is the principle's 'ability to observe the agent's performance' that determines the form of compensation. When accounting indicators can reflect reliable information about the manager's efforts, the appropriate form of contract is to pay a fix salary and panelize for suboptimal performance. However, if the appropriate actions are not 'observable', then tying the compensation with the firm's value can induce the employee to behave optimally (Holmstrom).

Similarly, Jensen argues that equity incentives can mitigate the agency problems when the separation of ownership and control cause the self-interested managers to act in the ways not beneficial to the shareholders. The main prediction of the agency model describes that design of executive compensation should be able to align the interests of management with the interests of shareholders and thereby induce managers to exert efforts to increase the firm value (Holmstrom and Milgrom).

Our first five hypotheses are based on the agency theory to explain the use of stock options in Japanese companies. Demsetz and Lehn suggest that firms may go for option-based compensation when direct monitoring is difficult (costly). Thus, it is reasonable to propose that a higher monitoring cost of business increases the probability of using stock options. The monitoring cost is an inverse function of capital to sales ratio of a company. Therefore, our first hypothesis is as follows:

Hypothesis: H-1.1:

Firms with a lower capital to sale ratio are more likely to use stock options

Large firms are difficult to monitor (Baker and Hall & Himmelberg, et al., (18)). Stock options can create mutual monitoring and peer pressure to create the economies of scale in monitoring. This implies a greater use of stock options in the large firms, both for executives and for employees. However, in case of employee stock options, a single employee can have a comparatively smaller role in contributing the total value of a large firm. In other words, employee stock options can produce greater incentive in the smaller firms as compared to the larger firms. This leads towards the following hypothesis:

Hypothesis: H-1.2:

The size of firm affects the likelihood of using stock options but the direction of relationship is to be asserted

The effect of firm size on the use of stock options can be positive and negative for executives and employees, respectively. Result of this hypothesis may help to define the preferences of the Japanese companies about using stock options with reference to their size. Previous work on the diversifications of firms shows a negative effect of diversification on the value of a firm, which some said a 'diversification discount'. A dominant part of diversification discount is caused by an increase in the agency cost in a diversified structure (Lamont and Polk (28)). This in turn can be explained by the fact that observing the performance is difficult in the diversified firms. Option grants can help to facilitate the monitoring mechanism in such firms. Hence, it is plausible to hypothesize as follows:

Hypothesis: H-1.3:

Diversified firms are more likely to use stock options

When films have low growth, the implications of employees' efforts are generally related to the maintenance of assets. However, the firms with high growth opportunities tend to have more concerns about the efforts of employees to attain the benefits of these opportunities (Milgrom and Robert). Aligning the interests of employees with the shareholders is crucial to get better performance in case of higher growth opportunities. Moreover, direct monitoring is difficult when a large part of the firm's value is acquired by utilizing the growth options (Demsetz and Lehn; Jensen and Meckling; Smith and Watts (28)). Thus, the firms with greater growth opportunities are expected to use stock options to capitalize their employees' efforts on these growth opportunities. We include two measures of the growth opportunities of a firm. First, from the point of view of a firm, it is reflected by the research and development (R&D ratio) expense of a firm. Second, from the point of view of market, it is presented by the value of Tobin's Q. Preceding discussion is summarized into the following two hypotheses:

Hypothesis: H-1.4:

Firms with a higher R&D expense are more likely to use stock options

Hypothesis: H-1.5:

Firms with a higher Tobin's Q value are more likely to use stock options

Retention and Sorting

While it is true that stock option compensation is mainly understandable as a mechanism aligning the interests of managers with the interests of shareholders, the underlying consideration behind this explanation is the ability of top executives to affect the value of a firm by their individual actions. For the employees however, it is difficult to explain the option-based compensation only with the agency theory. This is because; lower level employees can have a limited ability to affect the firm's value by their individual actions *******. This insufficient explanation of employees' stock options with the agency theory, leads towards two potential benefits of stock options in the form of retention and sorting of employees. As the employees are forced to the early suboptimal exercise of their options, the vested exercise period can help to retain the employees (Hale). Similarly, the risk associated with the option grants can help to attract the most suitable employees to work at the firm. These include less risk averse and more optimistic employees or the employees having abilities and skills to increase the value of a firm.

Though the use of stock options for retention and sorting purposes has received less attention in the previous literature, these motives are important to explain the use of stock options in the Japanese business environment. Long-term employment contracts in Japanese companies have been discussed frequently in research literature. Traditionally, Japanese companies have been putting special emphasis on the development of specific human capital by investing on the training and education of employees under the LTE contracts. However, since last one decade, the difficulty to maintain the traditional employment structure has exposed the companies to a risk of loosing their investment in the specific human capital (Suzuki). Other things being equal, the increasing use of stock options in Japanese companies is explainable as an effort to retain the valuable employees. Firms need long-term employment contracts to encourage potential managers remain with the firm and make decisions that can increase continuing performance (Fudenberg, et al., (29); Kole (30)). Retention of key employees becomes more important when employees can take with them some special information, knowledge, or skills that can be used by the competitors. Firms also tend to retain employees in the face of high cost of turnover, which includes the costs of re-hiring, training a replacement and lost productivity (Carter and Lynch (31)). This problem is evident when the cost of changing the job is lower for the employees. However, since employees are forced to a suboptimal early exercise of their options in case of departure from the firm, the use of stock options can help to balance the cost of turnover for the company with the cost of changing job for the employee.

In this perspective, an important question is that any form of compensation, a part of which is lost in case employees leave the firm can help with the retention. One way of doing this can be the deferred cash payment. However, stock options can help to maintain the aggregate incentive level for the employees in the face of changing labor market conditions (Kadia and Mazumdar (32)). Similarly, the option grants can help to load the risk on the employees as well as giving them chances of getting maximum benefits (Oyer and Schaefer). Moreover, if labor market conditions change, the deferred cash payment can become insufficient for employees or expensive for the firm, but stock options can act as a substitute of deferred payment when labor market conditions are positively correlated with the firm's stock price.

Preceding discussion leads towards next five hypotheses about the use of stock options for retention and sorting motives. When firms have considerable intangible assets and growth opportunities, the retention of key employees becomes critical for the value creation. The benefits of growth opportunities depend on the availability of potential employees in the company (Smith and Watts). While growth opportunities increase the likelihood of using stock options to align the interests of shareholders with the employees, if the growth opportunities are greatly related to the human capital, the use of stock options may also reflect the purpose of retaining the potential employees (Core and Qian (46)). Thus, it is reasonable to hypothesize as below:

Hypothesis: H-2.1:

Firms with a higher value of "growth opportunities per employee" are more likely to use stock options

When human capital has a vital role for the value creation and the firm has substantial investments on the development of firm-specific skills of employees, the retention of these employees becomes important for a firm. A higher wage level (wages per employee) in a company can indicate the importance of the human capital and thereby an increase in the likelihood of using stock options for the retention purpose. However, firms may also grant options to compensate the lower wage level in the company. In that case, the firms with a lower wage level may go for option based compensation. This leads towards following hypothesis:

Hypothesis: H-2.2:

The wage level in firm affects the likelihood of using stock options but the direction of relationship is to be asserted

The expected sign of wage level to define the use of stock options can be negative or positive. The result of this hypothesis may reflect the expectations of the Japanese companies in using stock options instead of cash payment. As discussed earlier, the concerns of loosing the talented employees to the competitors are expected to increase, when firms have a close competition. Firms are likely to use stock options to retain their key employees who can take with them some special skill or know-how that can be used by the competitors. Oyer and Schaefer (47) suggest that the firms with stock returns close to the industry returns are likely to compete for the same set of workers. Following this proposition, we suggest a greater use of stock options in the firms competing for the same set of workers. Thus, it is plausible to hypothesize as follows:

Hypothesis: H-2.3:

Firms having stock returns close to the industry returns are more likely to use stock options

Stock options also add a degree of risk in the compensation by tying the pay with the worth of a company. The risk associated with the option grants is explainable in two ways. On the one hand, literature on the valuation of stock options suggests that the managers having their human capital tied with the fate of the firm are less willing to increase the uncertainty by adding risk to their financial capital in the forth of stock options ********. Thus, from the firm's perspective, though the value of stock options is an increasing function of risk, the value of stock options perceived by the managers can be different (less) from the actual cost to the firm (Lambert, et al., (34); Muelbroek (35)). An increase in the risk level may enhance this difference in valuation (Aggarwal and Samwick; Jin). This implies that the increase in the risk may reduce the incentive level of stock options and makes it less likely for a firm to use stock options.

On the other hand, due to the risk associated with the stock options, different employees may value the options differently. It may be more attractive for the less risk averse employees, or for the employees having skills and abilities to take actions that can result in the improvement of firm value (Lazear). These employees may also enhance the value of options by using the insider information (Huddart and Lang (36)). Consequently, the option grants can help to make the compensation more attractive for a certain group of employees. Following this, Ittner, et al., (37) suggest that stock options can play a screening role to attract right type of employees to work at the firm. Similarly, Oyer and Schaefer argue that option grants can help to attract more optimistic workers that are willing to invest in the firm's specific human capital by hard working and to be more productive. This implies that the increase in the risk level may help to use stock options for sorting purpose. According to the preceding discussion, following is plausible to hypothesize:

Hypothesis: H-2.4:

The risk associated with the company stock affects the likelihood of using stock options but the direction of relationship is to be asserted

The incentive model and the sorting model give opposite signs for the role of risk in defining the use of stock options. The results of this hypothesis may help to define the preferences of Japanese firms to use option grants for the incentive purpose or for the sorting and attraction purpose. Similarly, when employees differ considerably about the future returns of a firm, it is possible to attract somewhat optimistic employees by using stock options. While large investments by the firm demonstrate higher growth expectations, the potential employees may vary considerably about the future value of these investments. Due to this variation, the option grants can be more attractive for a certain group of employees.

Hypothesis: H-2.5:

Firms with a higher investment to capital ratio are more likely to use stock options

Financial and Ownership Structure

As stock options do not need cash payment, companies with cash flow constraints may use stock options as a substitute of cash payment (Matsunga, et al., (38); Yermack (39); Core and Guey; Dechow, et al., (40)). Similarly, the companies with higher capital needs or facing a higher cost of accessing the capital markets may use equity compensation for employees (a). Therefore, it is plausible to hypothesize as below:

Hypothesis: H-3.1:

Firms facing cash flow constraints are more likely to use stock options

However, the use of stock options as a substitute of cash payment can be an expensive source of capital financing because of the 'deadweight loss' associated with it (b). Therefore, a company may have a disadvantage in using stock options for financing needs, rather than accessing outside investors. To resolve these contrary arguments, we associate the use of stock options as a substitute of cash payment with the sorting model. The risk associated with the stock options implies the variance in the potential employees' believes about the future returns of a firm. Some of the employees may be more optimistic about the returns of firm than the others. Thus, firm can get a compensation discount on the wage payments by attracting less risk-averse and more optimistic employees. In this way, stock options can become an efficient form of equity financing if company can attract the optimistic employees that can value the options greater than outside investors. Therefore, it is expected that the sorting considerations have an important role to define the use of stock options as a substitute of cash payment. Meanwhile, cash flow constraints may not be a necessary condition for the sorting motives.

A higher leverage indicates a higher risk associated with the firm. Thus, it can be expected that firms are less likely to increase the risk by granting options to induce managers for more risky decisions. Jensen (41) explains that disciplinary role of debt can reduce the need of an alternative mechanism of monitoring in the form of equity grants. On the other hand, Mehran (42) argues that adding risk to the compensation may help to align the risk preferences of investors with the representative managers. Thus, according to this point of view, firms with a greater leverage may be more inclined towards the use of stock options.

However, explaining the relationship of compensation policies and capital structure, John and John (43) argue that the equity compensation would urge managers to pursue higher risk strategies to increase the value of equity and the creditors will demand more risk premium to provide capital. Consequently, the firms with higher leverage are less likely to use stock options. Depending on these opposite views, the expected relationship of leverage with the use of stock options can be either positive or negative. The resultant sign of this hypothesis may help to explain the behavior of Japanese companies to go for stock options with reference to the level of leverage.

Hypothesis: H-3.2:

The level of leverage in firm affects the likelihood of using stock options but the direction of relationship is to be asserted

The preference and ability of the shareholders to provide an alternative source of monitoring can also help to explain the role of ownership structure in defining the use of stock options. Large shareholders are expected to have ability and interest to monitor firm (Hoskinsson and Turk (44)). The presence of this alternative mechanism of monitoring may reduce the need of equity incentives. Institutional owners are generally professional owners with specialized skills and know-how to organize the ways of monitoring (David, et al., (45)). The grant of stock options can provide a better symmetry between the firm's performance and employees' effort. Thus, firms with a higher degree of institutional ownership are expected to use stock options to efficiently monitor the firm. Preceding discussion suggests the following two hypotheses:

Hypothesis: H-3.3:

Firms with a higher ownership concentration arc less likely to using stock options

Hypothesis: H-3.4:

Firms with a higher degree of institutional ownership are more likely to use stock options

Table 1 summarizes the hypotheses according to three different theories. The first column presents the description of measures used in different hypothesis. Hypothesis number and expected signs are presented in the next two columns of this Table.

Variable definitions

As discussed earlier, the previous literature proposes a number of potential justifications of option grants for executives and employees. We construct the analyses around these various aspects and drive the implications of each in the Japanese business environment. A major difficulty in the available data is to define the employee stock option plans. Companies in Japan, often announce the number of managers and employees targeted in a stock option plan. Total number of option grants to these employees is also available. However, the number of option grants to each individual is not accessible. Within these limitations of available data, we take two considerations to define the employee stock option plans. First, Core and Guay define the employee stock options, when option grants are targeted towards the employees that are not among the top five executives of a company. Second, Oyer and Schaefer argue that a cut point of top five executives can overestimate the number of employee stock options, as in many firms, sixth or seventh top executive may also have a large number of option grants. Taking in view these two considerations, we classify the employee stock option plans, when the option grants are targeted towards at least 10 per cent of the total number of employees, after excluding the top five executives of the company.

The descriptions of independent variables are based on the discussions in the previous section. First five independent variables hypothesize the use of stock options according to the agency theory. Capital to sale ratio is used as a proxy for the monitoring cost. It is presented as the amount of capital divided by the total sale of a firm. It is denoted as CAP_SAL. The log of total assts stands for the firm size. It is coded as SIZE. A dummy variable presents diversification. It takes the value one it" company has more than fifty percent of sale in a single segment and zero otherwise. It is presented as DIVERSIF. We use two measures of growth opportunities. First, the research and development (R&D) expense scaled by the total assets of a firm and second, the value of Tobin's Q (market value of the assets divided by the book value of the assets). These are denoted as RD_RATIO and TOBIN_Q, respectively.

Next five variables hypothesize the use of stock options based on the retention and sorting model. Following Core and Qian (46), we use the growth opportunities per employee to proxy the role of human capital related to the growth options. It is calculated as the market value of equity minus book value of equity, divided by the total number of employees and coded as GRO_EMP. Firms also want to maintain the valuable employees when human capital is an important part of the value creation process. A higher wage level can indicate the worth of human capital in a company. The proxy of average wage of employees in a company presents this variable. It is calculated as the total wage expenses divided by the total number of employees in a company and presented as WAG_EMPL.

A strong competition between the firms may increase the likelihood of using stock options to retain the potential employees. Following Oyer and Schaefer, 'the competition for the same set of workers' is presented by the proxy of relationship between the firm's stock returns and the industry returns. The firms having returns close to the industry returns are expected to have strong competition for the same set of workers. To create this variable, each firm's monthly stock returns are regressed on the monthly stock returns of corresponding industry for a given year. R-square values from these regressions represent the proxy for this variable. The firms with a higher value of R square are likely to use stock options for the retention of key employees. This variable is noted as COMPITIN. Proxy of stock return volatility presents the risk associated with the firms' stocks. It is calculated as the standard deviation of the monthly stock returns of firm during the observation year and is denoted as RISK. Large investments present the greater variance in the potential employees' believes about the future value of these investments. The investment to capital ratio presents this variable. It is coded as INV_CAPT.

Finally, four variables explain the use of stock options based on the financial and ownership structure of a firm. The firms facing cash flow problems are unable to pay the dividends. It is a common measure used in previous research literature to define the cash flow constraints faced by firm. Following this, we present the cash flow constraints with a dummy variable having value one if firm does not pay any dividend in the observation year and zero otherwise. It is called cash flow constraint and denoted as CASHCON. The role of debt in defining the use of stock options is presented by the level of leverage in a company. Total debt divided by the totals assets of the company presents the leverage. LEVERAGE denotes this variable.

Ownership structure of a company may also explain the use of stock options. We use two measures of ownership structure of a firm. First, the ownership concentration; it is presented as the total percentage ownership of top ten shareholders. It is noted as OWN_CON. Second, institutional ownership; it is presented as the percentage of institutional shareholders in the ownership structure defines this variable. It is denoted as INST_OWN.

Different Approaches to Investigate the Hypotheses In this paper we use three different approaches to investigate the hypotheses.

* First. we analyze the characteristics of the firms using stock options. For this purpose, we describe the dependent variable as the "stock option plan in effect."

* Second, we investigate the determinants and motives of stock option plan announcement. In this regard, we define the dependent variable as the "stock option plan announcement."

* Third, we examine the motives of first time users of stock options. For this purpose, we use the dependent variable as "first time announcement of stock option plan."

In all three cases, initially we consider the executive stock option plans and then the employee stock option plans. These empirical specifications are discussed as follows.

Characteristics of the Firms Using Stock Options

In this part, we analyze the characteristics of the firms using option-based compensation. In this ease the dependent variable is the stock option plan in effect. It takes the value one if the firm has at least one stock option plan in effect during the year T and zero otherwise. First, it considers the executive stock option plans in effect and then employee stock option plans in effect. These empirical specifications are presented in Equation 1.

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (1)

where [[beta].sub.0], is a constant, [[beta].sub.1] to [[beta].sub.2] are the coefficients of different factors during the year 'T-1' and [epsilon] is the standard error factor.

Determinants of Stock Option Plan announcement

This part analyzes the determinants of stock option plan announcement. The dependent variable takes the value one if firm announces a stock option plan in the year T and zero otherwise. Again, first it considers the executive option plans and then only employee stock option plans. These specifications are presented in Equation 2.

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (2)

Determinants of Stock Option Plan Adoption

First time users of stock options may have different motives. To investigate this, finally we examine the determinants of first time stock option plan adoption. In this part, the dependent variable takes the value one if firm announces a stock option plan for the first time during the year T and zero otherwise. Similar to the previous settings, first it considers the executive stock option plans and then only employee stock option plans. Equation 3 defines these specifications.

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (3)

We use the sample of 12,896 firm-year observations of the listed companies of Tokyo Stock Exchange (between 1997 and 2004). Data are obtained from three different sources. Data about the announcement of stock option plans are obtained from the website of Daiwa Securities (c). This database presents all stock option plan announcements in Japan from 1997 to 2004. It gives information about the amount of options granted in an option plan, exercise price, the number of executives and employees targeted in an option plan, and the vested exercise period of stock options. Financial information is collected from 'Nikkei Economic Electronic Database System' (NEEDS). Information about the firm's annual stock returns, industry returns and annual dividend payment is collected from the 'Japan Securities Research Institute' (JSRI) CD-ROM database (d).

Nevertheless, the use of stock options as a non-cash compensation is comparatively new in Japan, the number of firms using this type of compensation schemes has increased significantly. Figure 1 shows the total number of stock option plans in effect among Japanese companies, in different years. Data is obtained from Daiwa Securities. There is an increasing tendency towards the use of option-based compensation as we move 1997 to 2004.

Table 2 shows the year wise number of 'first time stock option plan announcements', 'total stock option plan announcements' and 'stock option plans in effect'. Executive stock option plans and employees stock options are presented in parallel columns. These data are obtained from Daiwa Securities. An increasing trend towards the use of stock options is evident both for executives and for employees. However, the number of new stock option plan announcements increase at a decreasing rate.

Among the 1,612 sample companies of TSE 684 companies are using the stock option based compensation. Table 3 presents the number of option plan announcements by different firms, from 1997 to 2004. There are 928 non-adopting firms in the sample. Among 684 adopting firms, the majority of firms have one option plan announcements, while 13 firms have 8 stock option plan announcements.

The sample includes companies from 28 different industries. Table 4 presents the option plan announcements in different industries. These figures are presented as a percentage of total stock option announcements in the subsequent column. Almost all the major industries are using stock options as a compensation tool. The highest number of option plans is announced in the 'Wholesale and Retail' industries, while 'Fishery, Agriculture and Forestry' is at the bottom with only one stock option plan announcement.

Descriptive Statistics

Table 5 shows the descriptive statistics of independent variables for 12,896 firm-year observations of the sample companies (between 1997 and 2004). As stated earlier the data are obtained from 'Nikkei Economic Electronic Database System' (NEEDS) and the 'Japan Securities Research Institute' (JSRI) CD-ROM database. Variable descriptions and computations are explained at the bottom of the Table 5. In Table 6, the sample is divided into the "contracting sample" and "non-contracting sample." A firm-year observation is included in the contracting sample if there is at least one stock option plan in effect during the observation year otherwise it is included in the non-contracting sample. Table 6 presents the mean, median and standard deviation of the 'contracting sample' and 'non-contracting sample' in parallel columns. The last two columns of Table 6 show the signs and P-values of t-test and Wilcoxon-test to examine the significant difference between the means of observed factors. By comparing two groups, several interesting observations can be made about the characteristics of the firms using stock options.

Firms in the contracting sample tend to be larger than the firms in non contracting sample, which implies the use of stock options for the economies of scale in monitoring the large structure. Similarly, contracting sample contains the firms with a higher R&D ratio, and as expected, firms in this sample are higher valued, based on the Tobin's Q value. This is according to the proposition of using the stock options to capitalize the growth opportunities. Similarly, in contracting sample, firms have higher growth opportunities per employee. This supports the prediction of using stock options for retention purpose when growth opportunities are related to the human capital. Contrary to the idea that higher risk may reduce the use of option grants, the firms with greater stock return volatility tend to be in the contracting sample. Firms in the contracting sample have a higher investment to capital ratio. This sustains with the idea of using stock options to attract the suitable employees to work at the firm. These observations indicate the use of stock options for the benefits other than just a monitoring mechanism. Firms have a higher leverage in the non-contracting sample. Non-contracting sample on the other hand, includes the firms with greater ownership concentration. This is inline with the expectations that a monitoring structure in the form of big shareholders may reduce the use of stock options for monitoring purpose. However, a higher percentage of institutional owners in the contracting sample indicate the interest of institutional owners to use stock options as a market-based monitoring system. While the results of univariate analyses lend support to the hypothesized predictions, next section presents the multivariate analyses to analyze these aspects.

Regression Analyses

We use binomial logistic regressions to test our hypotheses. Correlation matrix and tolerance levels among the independent variables are presented in Table 7. There are no signs of co-linearity and the tolerance level among the independent variables rejects the exclusion of any variable from the regression.

Characteristics of the Firms using Stock Options

In this part, we use the estimating Equation 1 to analyze the characteristics of the firms using stock options for executives and employees. The results of binomial logistic regressions are presented in Table 8. The dependent variable is 'stock option plan in effect.' In panel A, the dependent variable takes the value one if there is at least one 'executive stock option plan' in effect during the observation year and zero otherwise. In panel B, the dependent variable takes the value one if there is an 'employee stock option plan' in effect during the observation year and zero otherwise.

Consistent with our hypothesis H-1.1, results indicate that the firms using stock options have higher monitoring cost in both panels. This explains the use of stock options to increase the efficiency of monitoring in case of executive stock option plans, and to get the economies of scale in monitoring in case of employee stock option plans. The results also indicate that large and diversified firms tend to use stock options both for executives and for employees. These results suggest a positive sign for hypothesis H-1.2 and support the hypothesized prediction of H-1.3. For executives, these results are in accordance with the findings of Jensen and Meckling (73) that explain the increase in monitoring difficulty with an increase in the size and diversification of a firm. For employee stock option plans however, the results show support to the suggestions of Kandel and Lazear that mutual monitoring and peer pressure created by the option plans, can help to persuade employees of large and diversified firms to increase the firm's value collectively. The results suggest an increase in the use of stock options with an increase in the growth options of a firm both in terms of R&D ratio and in terms of Tobin's Q value. These are consistent with our hypothesis H-1.4 and H-1.5. The use of equity incentives for executives and employees in greater growth opportunities is inline with the findings of previous studies in several ways. First, consistent with Smith and Watson (75), valuable growth opportunities increases the need of aligning the interest of shareholders with the managers. Second, in case of high growth options, the accounting measures become insufficient to measure the performance (Lembert and Larcker (76)). Third, stock options can reward managers and employees, over a multiple-years period in which the new projects are completed.

Results succeed quite well in predicting the use of stock options for retention and sorting purposes in Japanese companies. Though the greater growth opportunities increase the use of stock options both for executives and for employees, evidence suggests that employees are more likely to get stock options when the growth opportunities are strongly related to the human capital. This is inline with hypothesis H-2.1. Hypothesis H-2.2 gets positive sign in panel A and negative in panel B but remains insignificant in both panels.

Firms having stock returns close to the industry returns show more inclination towards the use of stock options. This supports hypothesis H-2.3 and verifies the prediction that the firms competing for the same set of workers use stock options to attract and retain the key employees. Japanese companies are more concerned about the retention of their valuable employees, as they have been putting substantial amount of investments on the development of firm-specific skills of employees under the traditional LTE system. Retention of these employees is an important issue due to the lack of any retention mechanism after the transitions in the traditional employment structure. Retention becomes more crucial when employees can take with them some special skill or. expertise that can be used by the competitors. Thus, the increasing use of stock options in Japan is consistent to explain with the retention needs of the Japanese companies. In this regard, an important finding is the increases in the use of stock options with an increase in the stock return volatility. This is in contrast with the idea of a lower use of stock options in high risk conditions due to the reduced incentive level of options in high risk. On the other hand, this sustains with the proposition of using risk to attract the less risk-averse and optimistic employees to work at the firm. Results show an increasing use of stock options when there is a greater variance in potential employees' believes based on the large investments by the firm. This is also supportive to the hypothesized idea of using stock options to attract the right type of employees to work at the firm.

The results of Table 8 lend some support to the use of stock options for cash flow constraints but it is significant only in panel B. However, since the regressions in this part analyze the stock option plan in effect, the role of cash flow constraints may not be visible even if it would have been a consideration at the time of adopting the option plan. The effect of cash flow constraints on the decision to go for option-based compensation might be better translated when determinants of stock option plan announcement are analyzed in the next two parts. A related issue is the use of stock options with reference to the level of leverage in a company. Hypothesis H-3.2 gets negative significant sign, which shows that firms with a greater leverage are lower user of stock options. This is in contrast with the view that use of stock options can bring the risk preferences of managers closer to the representative investor (e.g., Mehran). However, this is accommodating the idea of Jensen (78) that the disciplinary role of debt reduces the need of an alternative mechanism of monitoring.

Inline with the hypothesized prediction H-3.3, results indicate that the presence of big shareholders reduces the use of stock options. Though the monitoring cost is distributed among the shareholders, big r-shareholders are expected to be concerned about their part of monitoring cost. Due to this reason, big owners might be more interested to monitor the firm directly rather than using the option grants. Similarly, evidence confirms the hypothesis H-3.4 that institutional shareholders prefer to use market-based measures to analyze the performance of managers and employees. While comparing the outcomes of panels A and B, though the agency theory is supported in both panels, the results are more favorable for the sorting and retention model in case of employee stock option plans. The financial and ownership structure got consistent results in both cases to sustain with the hypothesized predictions. Moreover, as the underlying reason behind the considerations of financial and ownership structure, is the incentive effect of stock options, it is also confirming the results of agency theory.

In some cases results show mix support both for executive stock options and employee stock options. One reason for this is that it is not possible to completely distinguish the executive stock options from employee stock options with the available data. For instance when we consider the executive stock options in panel A, it also includes the cases of employee stock options, because when companies have employee stock options, generally they also have the executive stock options. The other possible reason of getting mix results is that three theories are not mutually exclusive, completely. These are shared commonalities and ultimately lead towards better alignment between the owners and management/employees. However, the results are able to translate the preferences of the companies in adopting different approaches for executive stock options and employee stock options based on the implications of these theories.

Determinants of Stock Option Plan Announcement

The estimating Equation 2 examines the determinants of stock option plan announcement in Japanese companies on the basis of three different theories presented earlier in this paper. Table 9 shows the results of binomial logistic regressions. The dependent variable is the 'stock option plan announcement.' In panels A and B, it takes the value one if firm announces an 'executive stock option plan' during the observation year and zero otherwise. In panels C and D, the dependent variable takes the value one if the firm announces an 'employee stock option plan' during the observation year and zero otherwise. Panels A and C present the main regression according to the estimating Equation 2, while panels B and D include the interacting variables. In this part, we discuss the main regression results presented in panels A and C, while results of panels B and D would follow :

The results of first three variables show support to the agency theory for the executive stock options, but these variables cannot get the significant level as a motive for employee stock options. This is in agreement with the findings of previous studies (i.e., Holmstrom; Holmstrom and Milgrom; Jensen) that stock options can help to induce managers to make decisions inline with the requirements of shareholders. However, as lower level employees can have a little direct influence on the decision making process, the incentive alignment considerations are insufficient to explain the employee stock options. Results indicate that the greater growth opportunities lead towards the use of stock options both for executives and for employees. However, similar to the previous regressions, when growth opportunities are greatly related to the employees of a firm the results are significant only for employee stock option plans. This supports the hypothesis about the use of employee stock options for retention purpose to capitalize the growth opportunities with the help of valuable employees in the company.

Meanwhile, when firms are close competitors the results support the use of employee stock option plans. This is inline with the prediction of Oyer and Schaefer that firms use employee stock options for the retention purpose when they fear to lose the potential employees to the close competitors. Consistent with the previous regressions, an important finding is that a higher risk and greater investments lead towards the greater use of stock options both for executives and for employees. While a higher risk and large investments add a degree of uncertainty about the future outcomes of a firm, it can increase the chances of sorting and attraction of the right type of employees to work at the firm. Thus, the results are in contrast to the view of using stock options on l y for the incentive purpose. These results explain the preferences of Japanese companies to use stock options for sorting and retention of suitable employees to work at the firm.

Results lend a partial support to the relationship between the cash flow constraints and the likelihood of using stock options, which may complement partly with the use of stock options to overcome the cash flow shortage. However, this discards the use of stock options as a substitute of cash, exclusively for cash flow constraints. Moreover, as the sorting considerations have got the consistent results, it holds with the proposition to relate the grant of stock options as a substitute of cash payment with the sorting model. This in turn can be explained that stock options serve as an inexpensive source of capital financing only when they are used to attract the optimistic employees to work at the firm. Consistent with the results of previous part, it is evident that disciplinary role of debt as an alternative mean of monitoring reduces the use of stock options. These results are also in line with the explanation of John and John (83) which argues that a higher leverage with an option-based pay is not a successful combination, because in such cases, creditors demand more risk premium due to the chances of risky decisions by the managers. Inline with the expectations, results show a lower use of stock options in a higher degree of ownership concentration. One the other hand, the use of stock options increases with an increase in, the institutional ownership.

While comparing the results of panels A and C, the results of this part translate a comparatively clearer difference in the motives of executive stock options and employee stock options. The agency theory gets greater support in case of executive stock options and only a limited support in case of employee stock options. On the other hand, the sorting and retention model gets better results in case of employee stock options and a partial support in case of executive stock options. Variables related to the financial and ownership structure get consistent results in both cases, except cash flow constraint that is not significant for employee stock option plans.

Determinants of Stock Option Plan Adoption

Estimating Equation 3 investigates the motives of the first time stock option plan adoption. Table 10 presents the results of binomial logistic regressions. The dependent variable is the 'first time stock option plan adoption.' In panels A and B, it takes the value one if firm announces an 'executive stock option plan' for the first time during the observation year and zero otherwise. In panels C and D, the dependent variable takes the value one if the firm announces an 'employee stock option plan' for the first time during the observation year and zero otherwise.

Panels A and C of Table 10 present the main regression according to Equation 3. In case of first time stock option plan adoption a higher monitoring cost (based on capital to sale ratio) turns out to be insignificant reason to go for stock options. However, size, diversification and growth opportunities sustain as important motives both for executive stock options and for employee stock options. Similar to the results of previous two parts, the greater growth opportunities related to the employees show support to go for employee stock option plans. Risk gets the predicted sign in case of executive stock options and gets the predicted sign as well as the significant level in case of employee stock options. This confirms the results of previous parts about preferences of Japanese companies to use stock options for sorting and retention of valuable employees.

Large investments lead towards the adoption of stock-based compensation both for executives and for employees. Cash flow constraints provide a partial support to adopt the employee stock option plans. Consistent to the previous parts, higher leverage and ownership concentration reduce the chances of using stock options while firms with a higher institutional ownership are likely to adopt the option-based compensation. While comparing the results of executive stock options and employee stock options, it is evident that first time adoption decision also involves the sorting and retention considerations in case of employee stock options. However, the evidence suggests that firms give more weight to the incentive considerations when they decide to go for option-based compensation for the first time.

Cash Flow Constraints vs. Sorting Considerations

As discussed in the literature review, the use of stock options as a substitute of cash payment is better understandable with the help of sorting motives. Earlier regressions (panels A and B of Table 8, and panels A and C of Tables 9 and 10) are able to provide a consistent support to the sorting model, especially when employee stock options are used to define the dependent variable. On the other hand, the use of stock options in Case of the cash flow constraints cannot get a sustainable support in these regressions. These results may explain the rationale of using stock options as a substitute of cash for sorting purpose, even without cash flow constraints. However, it is important to investigate the two conditions simultaneously to see the preferences of Japanese companies about using these two approaches.

In addition, the use of stock options for cash flow constraints without the sorting considerations may be less attractive for the companies because of the reason that stock options can be an expensive source of financing without attracting less risk-averse and optimistic employees. Therefore, finally we analyze the use of stock options as a substitute of cash payment with the sorting considerations.

As a higher risk level presents the greater chances of sorting and attraction of the certain type of employees, it is appropriate to analyze the role of risk in case of cash flow constraints. Thus, we hypothesize that cash flow constraints with a high risk can make it more favorable to use stock options, because of the greater chances of sorting and attraction of potential employees. For this purpose, the interaction of CASHCON and RISK is included in the regression. Panels B and D of Tables 9 and 10 show the results of regressions with the interaction of variables. Though an increase in the risk level alone, leads towards the greater use of stock options, a higher risk with the cash flow constraints produce greater coefficient value than otherwise. This is inline with the prediction that companies consider the sorting motives when using stock options as a substitute of cash payment. However, it is difficult to differentiate these two conditions completely, as the measures for both are interrelated. While it is to acknowledge that there are limitations of defining these conditions with the available data, we do not present these two as necessary conditions for each other. Our analyses suggest that both risk and cash flow constraints can lead towards the option-based compensation in certain circumstances but the situation becomes more favorable for the use of stock options when these conditions happen together.

Conclusions

This paper reveals several issues of compensation literature by examining the use of stock options in Japanese companies. Previous research provides the motives of option-based compensation predominantly based on agency theory. However, the findings of this analysis suggest that if the option grants to employees are not driven by the incentive reasons, then the choice of stock options over cash is best explained by the theories involving retention and sorting of employees. The vesting period of stock options can help to retain the potential employees and if some of the potential employees are somewhat risk-tolerant, then the risk associated with the stock options can help for the sorting and attraction of such employees to get a compensation discount in the wage payments.

Overall the findings of this analysis are supportive for the agency theory in case of executive stock option plans while the retention and sorting model get more sustainable results in case of employee stock option plans. Financial and ownership structure support both the executive stock options and employee stock options with a consistency in expected signs in both cases. While it is evident that no single theory can explain the use of stock options exclusively, the results show partial support from different aspects to define the motives of the executive stock options and employee stock option plans. Agency theory succeeds fairly well in defining the executive stock options but the results cannot sustain with the agency theory as a principle motive to explain the employee stock options. Results are most consistent o with the retention and sorting model when employee stock option plans are considered. Meanwhile, retention and sorting model also sustains in case of executive stock option plans.

An important finding is the greater use of stock options with an increase in the firm's stock return volatility. This is in contrast with the idea of a lower use of option grants in the high risk conditions. On the other hand, these findings suggest the sorting motives as an important reason to go for option-based compensation in Japanese companies. Similarly, evidence suggests that firms use stock options to attract the optimistic employees when there is greater variance in the potential employees' believes about the future returns of the firm. The findings indicate that firms can take the advantage of compensation discount on the wage payments by attracting optimistic employees who may prefer the option grants to the equally costly cash payment. Thus, stock options can serve as a source of low cost capital financing by issuing shares to less risk-averse employees when firm has a difficulty in accessing the capital markets.

The use of stock options as a substitute of cash is not fully explainable with the incentive model presented in the previous studies. Findings of this analysis explain the substitute use of stock options against the cash payment with the sorting considerations. It is to acknowledge that the limitations of defining the substitute effect of stock options with the consideration of sorting motives, can doubt the results. However, the greater use of stock options for sorting purpose in case of cash flow constraints, sustain with the hypothesized prediction. These findings lend support to the prediction that use of stock options as a substitute of cash payment can be an optimal choice when there are greater chances of attracting the risk tolerant and optimistic employees.

This analysis also has some limitations related to the available data of stock options in Japan. As the data about the number of stock option grants to a single executive or employee, is not accessible in Japan, it is difficult to completely distinguish the executive stock options and employee stock options. More detailed data may give a clearer picture of the determinants and motives of stock options. Similarly, we discuss the increasing use of stock options with reference to the unique institutional characteristics of Japanese business environment and requirements of companies after the burst of bubble economy. The findings may have limitations for the different business environments. A great deal of complexity associated with the use of stock options also limits examining it comprehensively. In this regard, the mutual exclusiveness of three theories is arguable as some time they can complement each other. However, we try to find out the parallel justifications of these theories to distinguish the implications of each in the Japanese business environment.

BRIEF PROFILE OF TOKYO STOCK EXCHANGE (TSE)

Tokyo Stock Exchange (TSE) is one of the world's major stock exchanges. The history of TSE dates back to 1970s when The Tokyo Stock Exchange Co., Ltd. was established on May 15,1978. Trading on the exchange was suspended during the World War-2 from 1945 to 1949. After several reorganizations in the post-war era, TSE has emerged as the largest Stock Exchange in Asia. Today there are approximately 2400 companies listed on the exchange with a total market capitalization of about 408 trillion yen.

Historically, the liquidity in Japanese stock markets has been lower than that in the US markets. The mechanism of equity trading at the TSE is also different from that used in the US. The exchange-designated specialists in the US markets maintain the liquidity. These specialists continuously offer buy and sell quotes to control the price difference between the trades. At the TSE, however, there is no such mechanism. The liquidity at TSE is controlled through a check on maximum price change between the transactions.

Japan's fast economic growth in the post-war era continued to increase the stock market value at an accelerated rate. In early 90s, however, a slowdown in the economy brought a large decline in the liquidity of stock market. Consequently, investors were forced to sell their shares at much lower value. A prolonged deflation during the rest of the decade stabilized the stock market at a significantly lower level. Meanwhile, shareholders raised voices to protect their interests in the company decisions. Under these moves, the Japanese government amended the commercial code in 1997 to allow the grant of stock options. These amendments were welcomed and there has been an increasing trend towards the use of stock options in Japanese companies. For the option grating companies, the change in the stock prices became a direct incentive for the management and an important measure of performance for the shareholders. The unique history of TSE and the legacy of traditional corporate governance in Japan, present an opportunity to analyze the option grants in this distinctive business environment. In this paper, we used the framework of three different theories to analyze the motives and expectations of option grants in Japanese companies. For this purpose, we used the cross sectional data of 1612 listed companies of TSE, from 1997 to 2004.

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HAMID HASSAN, Ph.D.

Associate Professor

FAST Business School, National University of Computer & Emerging Sciences

Lahore Campus

Lahore-4700, PAKISTAN

Professor YASUO HOSHINO, Ph.D.

Professor

Graduate School of Accounting

Aichi University

Nagoya-461-8641, JAPAN

and

Professor Emeritus

Graduate School of Systems and Information Engineering

University of Tsukuba, Tsukuba 305-0006, JAPAN

* Recently, for instance, Ahmadjian (1) explains the transformations in the traditional corporate governance structure of Japanese companies (also see, Kato (2)).

** Exceptions are Kato, et al. (3) and Uchida (4)

*** See, for details, Suzuki (21).

**** Because of the risk associated with the stock options, managers and employees may value the options less than the market value (see, for instance, Barron and Weddel (26)).

***** Kaplan (27) reported that managerial equity ownership of Japanese companies in 80s was half of that in the US companies.

****** Option grants that fulfil several conditions (such as, exercise price is equal to or greater than the share price at the time of grants) are categorized as 'tax-qualified stock options.'

******* With the grant of stock options, employees can show commitment and devotion to their duties and responsibilities in their specific area of work to make it valuable for the company's progress, but direct effect of their individual actions on the overall value of the firm remains minimal (see, e.g., Core and Guay).

******** Managers risk their human capital with the firm performance because, future demand and job-opportunities for them are greatly related to the success and achievements of existing firm (see for details, Carpenter (33))

(a) According to Core and Guay, as the information asymmetry is lower between the firm and its employees than between the firm and the outside investors, the equity compensation can serve as an inexpensive devise as compare to the costly outside equity financing.

(b) Studies on the risk associated with the equity incentives explain that due to the inability of hedging the risk, employees and managers may value the stock options less than its cost to the company. Thus, according to Meulbroek, firm has to bear the difference in this valuation as a "deadweight loss" for the compensation package (also see, for details, Carpenter and Jin)

(c) Information about the announcements of stock option plans in Japan, are available at http://www.daiwasmbc.co.jp/index.html)

(d) CD-ROM database 'Stock investment rate of return' is published every year by the 'Japan Securities Research Institute' (JSRI), (Information about the database are available at http//wwwjsrior.jp.

The authors are grateful to the referees of JFMA Journal for useful comments and suggestions

The authors own full responsibility for the contents of the paper.
TABLE 1
SUMMARY OF HYPOTHESES ABOUT THE
ALTERNATIVE THEORIES CONCERNING THE
USE OF STOCK OPTIONS

Descriptions                  Hypotheses   Expected signs

1-AGENCY THEORY
Capital to sale ratio           H-1.1            -
Firm size                       H-1.2            /-
Diversification                 H-1.3            +
R & D ratio                     H-1.4            +
Firm's value (Tobin's Q)        H-1.5            +

2-RETENTION &SORTING
Growth opportunities per
employee                        H-2.1            +
Wages per employee              H-2.2           +/-
Competition                     H-2.3            +
Risk                            H-2.4           +/-
Investment to capital ratio     H-2.5            +

3-FINANCIAL AND OWNERSHIP STRUCTURE
Cash flow constraint            H-3.1            +
Leverage                        H-3.2           +/-
Ownership concentration         H-3.3            -
Institutional owners            H-3.4            +

TABLE 2
DISTRIBUTION OF STOCK OPTION PLANS ACROSS DIFFERENT YEARS (a)

       First time Stock option  Total Stock option plan
          plan announcements       announcements

          For          For         For          For
Year   Executives   Employees   Executives   Employees

1997       74          38           74          38
1998       47          25           74          34
1999      186          101         244          120
2000      109          71          261          131
2001      122          85          321          152
2002       84          78          338          154
2003       59          58          322          174
2004       56          4L          304          160

       Total Stock option plan
            in effect

          For          For
Year   Executives   Employees

1997       74          38
1998      121          63
1999      307          164

2000      410          228
2001      520          303
2002      586          383
2003      630          434
2004      684          470

Notes : The Table displays the distribution across years of total
1,938 stock option plan announcements among the listed companies of
Tokyo Stock Exchange. An option plan is categorized as employee
stock option plan when it is targeted towards more then ten percent
of the total number of employees, after excluding the five top
executives of the company. First two columns show the first time
option plan announcement events in different years. Total number of
option plan announcements and the number option plans in effect
during a given year is also shown in the subsequent columns.

TABLE 3
DISTRIBUTION OF STOCK OPTION PLAN
ANNOUNCEMENTS PER FIRM *

 No. of
option     No. of    Percentage
 plans      firms     of total

   1           215        31.43
   2           151        22.07
   3            95        14.03
   4            84        12.42
   5            55         8.04
   6            48         7.16
   7            19         2.92
   8            13         1.90
 Total         684          100

Note: * Number of option plan announcements among the
684 adopting firms between 1997 and 2004.

TABLE 4
OPTION PLAN ANNOUNCEMENTS ACROSS
DIFFERENT INDUSTRIES BETWEEN
1997 AND 2004

                         No. of stock     Percentage
Industry name             option plan      of total
                         announcements   announcements

Glass and ceramics                  23            1.18
Rubber products                      2            0.10
Services                            50            2.50
Other products                      19            0.98
Pulp and paper                      28            1.44
Real estate                         51            2.63
Warehousing and harbor
  transport services                 9            0.46
Chemical sand
pharmaceuticals                    135            6.96
Wholesale and retail               329           16.97
Construction                       118            6.08
Transportation and
  communication                    132            6.81
Machinery                          198           10.26
Fishery, agriculture
  and forestry                       1            0.05
Marine transport                    20            1.03
Oil and coal products               20            1.03
Air transport                        5            0.25
Precision Instruments               55            2.83
Textile and apparel                 77            3.97
Transport equipment                 85            4.38
Metal products                      44            2.27
Financial institutions              35            1.80
Steel products                      55            2.83
Mining                               9            0.46
Land transport                      43            2.21
Electric power and gas              27            1.39
Electrical machinery               142            7.33
Nonferrous metal                    42            2.16
Foods                              183            9.44
Total                             1938          100.00

TABLE 5
SUMMARY OF DESCRIPTIVE STATISTICS OF INDEPENDENT VARIABLES *

Variable   Description               Mean    Median   Std. Dev.

CAP-SAL    Capital to sale ratio      0.71     0.60        0.43
SIZE       Log of total assets       10.17    10.58        2.03
DIVERSIF   Diversification            0.55     1.00        0.49
RD_RATIO   R&D ratio                  0.08     0.07        0.06
TOBIN_Q    Tobin's Q                  0.99     1.00        0.40
GRO_EMPL   Growth opportunities
             per employee            -2.54    -1.40       18.64
WAG_EMP    Wages per employee         5.49     5.39        1.34
COMPITIN   Firm's returns compared
             to industry returns      0.27     0.27        0.22
RISK       Monthly stock return
             volatility              10.73     9.88        5.14
INV CAPT   Investment to capital
             ratio                    0.60     0.47        0.48
CASHCON    Cash flow constraint       0.19     0.00        0.31
LEVERAGE   Leverage                   3.50     2.28        4.32
OWN_CON    Ownership concentration   17.43    20.02       11.21
INST_OWN   Institutional ownership    0.26     0.24        1.36

Variable    Min.    Max.    Skewness

CAP-SAL      0.04    1.12       0.26
SIZE         3.09   16.20      -0.16
DIVERSIF     0.00    1.00      -0.23
RD_RATIO     0.00    0.18       0.14
TOBIN_Q      0.38    3.43       0.16
GRO_EMPL
           -39.88   49.03       0.39
WAG_EMP      2.11   17.39       0.10
COMPITIN
             0.00    0.80       0.05
RISK
             2.48   36.56       0.03
INV CAPT
             0.06    1.65       0.68
CASHCON      0.00    1.00       0.05
LEVERAGE     1.09    7.09       0.02
OWN_CON      0.01   89.10       0.66
INST_OWN     0.00   10.92       0.89

Notes : * The sample consists of 12,896 firm-year
observations of the listed companies of Tokyo stock exchange
(Between 1997 and 2004). Capital to sale ratio is the book
value of capital divided by the total annual sale of a
company. Log of the total assets represents the size of of a
company. Diversification is presented by a dummy variable
taking value one if a company has more than fifty percent
sales in a single segment, and zero otherwise. Research and
development (R&D) expanse divided by the total assets
defines the ratio. Tobin's Q is the market value of assets
(book value of liabilities + market value of equity) divided
by the book value of assets. Growth opportunities per
employee is the market value of equity minus book value of
equity (in millions of yen), divided by the number of
employees. Wages per employee is presented as the total
wages expanse (in millions of yen) divided by the number of
employees in returns of each a firm. Competition is presented
by the proxy of R-square values, obtained by running the
regressions of monthly stock firm stock over the monthly
stock returns of related industry during the observation
year. A proxy of standard deviation of the monthly returns
of a firm during the observation year defines the risk.
Investment to capital ratio is the total investments during
the year, divided by the book value of capital. Cash flow
constrain is presented by a dummy variable taking value one
if firm has no dividend payment during the observation year
and zero otherwise. The total debt divided by the total
assets presents the leverage. Ownership concentration is the
percentage of shares held by the ten largest shareholders of
a firm. Institutional ownership is the percentage of shares
held by the institutional owners. To avoid the effects of
outliers, all the continues variables are winsorized at the
1st-and 99th-percentiles

TABLE 6
DESCRIPTIVE STATISTICS AND TEST OF SIGNIFICANT DIFFERENCE BETWEEN
THE CONTRACTING SAMPLE AND NON-CONTRACTING SAMPLE *

                     Mean                        Median
                             Non-                         Non-
            Contracting   contracting   Contracting   contracting
Variables     sample        sample        sample        sample

CAP_SAL         0.71          0.71          0.56          0.61
SIZE           11.31          9.90         11.15         10.44
DIVERSIF        0.77          0.50          1.00          1.00
RD_RATIO        0.01          0.01          0.00          0.00
TOBIN_Q         1.09          0.96          1.00          1.00
GRO_EMPL        1.92         -3.63         -0.42         -1.67
WAG_EMP         5.45          5.50          5.36          5.54
COMPITIN        0.27          0.27          0.27          0.27
RISK           11.12         10.63          9.93          9.87
INV_CAPT        0.83          0.54          0.73          0.40
CASHCON         0.10          0.21          0.00          0.00
LEVERAGE        2.58          3.73          1.93          2.24
OWN_CON         4.28         20.81          0.07         20.05
INST_OWN        0.56          0.19          0.05          0.03

             Std. Dev.                       P-value
                             Non-
            Contracting   contracting    t-test    Wilcoxon
Variables     sample        sample                  -test

CAP_SAL          0.54         0.40       (-)0.805    0.052
SIZE             1.47         2.05       (+)0.000    0.001
DIVERSIF         0.41         0.49       (+)0.000    0.019
RD_RATIO         0.01         0.01       (+)0.001    0.001
TOBIN_Q          0.57         0.35       (+)0.000    0.001
GRO_EMPL        21.18        17.80       (+)0.001    0.008
WAG_EMP          1.32         1.35       (-)0.295    0.075
COMPITIN         0.21         0.22       (+)0.953    0.272
RISK             5.83         4.94       (+)0.000    0.104
INV_CAPT         0.40         0.48       (+)0.018    0.001
CASHCON          0.31         0.41       (-)0.312    0.215
LEVERAGE         2.25         4.62       (-)0.001    0.003
OWN_CON         16.29         5.82       (-)0.001    0.021
INST_OWN         1.97         1.15       (+)0.001    0.002

Notes : * Total sample consists of 12,896 firm-year
observations of the listed companies of Tokyo stock exchange
(Between 1997 and 2004). Table divides the sample in two
groups: contracting sample and non-contracting sample. A
firm-year observation is included in the contracting sample
if there is at least one stock option plan in effect during
the observation year otherwise the observation is included
in the non-contracting sample. The last two columns report
the signs and P-values of t-test and Wilcoxon test between
the contracting sample and non-contracting sample (assuming
the equality of means). To avoid the effects of outliers,
all the continues variables are winsorized at the 1st-and
99th-percentiles.

TABLE 7
CO-LINEARITY STATISTICS AND PEARSON CORRELATION MATRIX OF
INDEPENDENT VARIABLES

Variable      Tolerance       1          2         3         4

1-CAP_SAL       0.86       1
2-SIZE          0.88       0.02 *     1
3-DIVERSIF      0.88      -0.08 **    0.07 **   1
4-RD_RATIO      0.95       0.09 **    0.03      0.13      1
5-TOBIN_Q       0.77      -0.45 **   -0.04      0.07 *    0.05 *
6-GRO_EMPL      0.67      -0.13 **   -0.07 *    0.09 *    0.08 **
7-WAG_EMP       0.99       0.02 *    -0.02 *   -0.02 *    0.00
8-COMPITIN      0.99       0.02 *    -0.02 *    0.00      0.00
9-RISK          0.92      -0.06 *     0.01 *   -0.05 *    0.01
10-INV_CAPT     0.63      -0.22 **   -0.02 *    0.10 *   -0.05 *
11-CASHCON      0.78       0.11 *     0.07      0.15 *    0.03 *
12-LEVERAGE     0.67      -0.26 **   -0.17 *   -0.06 *   -0.13 **
13-OWN_CON      0.75       0.02 *    -0.24 *   -0.15 *   -0.07 *
14-INST_OWN     0.72       0.05 *    -0.06 *    0.02     -0.01

Variable          5         6        7       8        9        10

1-CAP_SAL
2-SIZE
3-DIVERSIF
4-RD_RATIO
5-TOBIN_Q      1
6-GRO_EMPL     0.37 *     1
7-WAG_EMP      0.00       0.00       1
8-COMPITIN     0.03 *     0.02       0.00    1
9-RISK         0.17 **    0.17 **    0.00    0.01    1
10-INV_CAPT    0.09 **    0.13 **   -0.00   -0.01    0.08 **    1
11-CASHCON    -0.06 *    -0.14 **    0.00    0.01   -0.17 *    -0.27 *
12-LEVERAGE    0.02       0.03       0.00    0.00    0.09 **    0.54 **
13-OWN_CON     0.02      -0.11       0.01    0.00    0.02 *    -0.16 *
14-INST_OWN    0.14 **    0.09 **    0.02    0.01    0.03 *     0.01

Variable         11        12        13      14

1-CAP_SAL
2-SIZE
3-DIVERSIF
4-RD_RATIO
5-TOBIN_Q
6-GRO_EMPL
7-WAG_EMP
8-COMPITIN
9-RISK
10-INV_CAPT
11-CASHCON      1
12-LEVERAGE    -0.29 *    1
13-OWN_CON     -0.07 *    0.05 *    1
14-INST_OWN     0.04     -0.02 *    0.36 **   1

Notes: * significant at the 5 percent level; ** significant
at the 1 percent level

TABLE 8
CHARACTERISTICS OF THE FIRMS USING
STOCK OPTION PLANS
(STOCK OPTION PLAN IN EFFECT) (a)

Variable              Panel-A        Panel-B-

Constant              -3.267 ***      -5.901 ***
                     (-5.61)        (-13.82)
CAP_SAL               -0.228 *         0.227 **
                     (-1.61)          (2.63)
SIZE                   0.407 ***       0.254 ***
                      (8.10)          (8.66)
DIVERSIF               0.099           0.421 ***
                      (0.97)          (4.95)
RD_RATIO               5.714 **        7.480 ***
                      (1.67)          (3.26)
TOBIN_Q                0.168 *         0.054
                      (1.65)          (0.57)
GRO_EMPL               0.003           0.013 ***
                      (0.71)          (4.58)
WAG_EMP                0.007          -0.002
                      (0.22)         (-0.07)
COMPITIN               0.285           0.362 **
                      (1.53)          (2.13)
RISK                   0.061 ***       0.047 ***
                      (5.85)          (7.07)
INV_CAPT               1.172 ***       1.250 ***
                      (9.20)         (10.86)
CASHCON               -0.033           0.267 **
                      (0.21)         (-2.24)
LEVERAGE              -0.183 ***      -0.174 ***
                     (-4.98)         (-3.75)
OWN_CON               -0.320 ***      -0.049 ***
                    (-22.71)         (-9.85)
INST_OWN               1.561 ***       0.205 ***
                     (20.59)          (6.34)
Pseudo [R.sup.2]       0.80            0.28
Log likelihood     -1,103.53        -2,583.16
Chi- square           812.27 ***     1,049.08 ***
N                     12,896           12,896

Notes:

* significant at the 10 percent level;

** significant at the 5 percent level;

***significant at the 1 percent level.

Numbers in parentheses report the Z-statistics computed on
the bases of robust standard errors

(a) The Sample consists of 12,896 firm-year observations
between 1997 and 2004. The dependent variable is 'stock
option plan in effect.' In panel-A, the dependent variable
takes value one if the firm has at least one 'executive
stock option plan' in effect during the observation year and
zero otherwise. In panel-B, the dependent variable is
employee stock option plans' (stock option plans that are
targeted towards more then 10 percent of the employees after
excluding the top five executives of the company). It takes
the value one if the firm has at least one employee stock
option plan in effect during the observation year and zero
otherwise. All the independent variables are lagged one-
year. To avoid the effects of outliers, all continues
variables are winsorized at the 1st-and 99th-percentiles.

TABLE 9
DETERMINANTS OF STOCK OPTION PLAN ANNOUNCEMENT
(STOCK OPTION PLAN ANNOUNCEMENT) (a)

Variable              Panel-A          Panel-B          Panel-C

Constant               -3.508 ***       -3.369 ***       -1.093
                      (-8.24)          (-7.61)           (0.41)
CAP_SAL                -0.119 *         -0.116 *          0.071
                      (-1.37)           (0.17)           (0.80)
SIZE                    0.283 ***        0.283 ***        0.035
                       (9.15)           (8.59)           (1.24)
IVERSIF                 0.299 ***        0.301 ***        0.083
                       (3.11)           (3.12)           (0.74)
RD RATIO                6.962 ***        6.95 *           4.701 **
                       (2.42)           (2.34)           (1.45)
TOBIN_Q                 0.12             0.14             0.30 **
                       (0.10)           (0.10)           (2.42)
GRO_EMPL                0.004            0.004            0.005 *
                       (1.35)           (1.33)           (0.21)
WAG_EMP                -0.030           -0.031           -0.013
                      (-0.01)          (-0.01)          (-0.40)
COMPITIN               -0.006           -0.005            0.385 **
                      (-0.03)          (-0.02)           (1.93)
RISK                    0.056 **         0.033 **         0.047 ***
                       (7.25)           (5.26)           (5.77)
INV_CAPT                0.355 ***        0.357 ***        0.591 ***
                       (2.80)           (2.91)           (4.57)
CASHCON                 0.263 **         0.391 *          0.151
                      (-1.93)           (0.98)           (0.87)
LEVERAGE               -0.108 ***       -0.107 ***       -0.128 ***
                      (-4.27)           (3.13)           (3.07)
OWN_CON                 0.196 ***       -0.197 ***       -0.151 ***
                     (-20.71)          (21.23)         (-13.24)
INST_OWN                0.993 ***        0.994 ***        0.767 ***
                      (18.96)          (19.09)          (15.12)
CASHCON X RISK          0.060 ***        0.052 **        (6.88)
Pseudo [R.sup.2]        0.50             0.59             0.31
Log likelihood     -2,103.7         -1,721.21        -1,731.34
Chi-square          1,142.80 ***       711.25 ***     71636 ***
N                  12,896           12,896           12,896

Variable              Panel-D

Constant               -2.832 ***
                      (-6.11)
CAP_SAL                 0.094
                       (0.85)
SIZE                    0.036
                       (1.27) D
IVERSIF                 0.071
                       (0.63)
RD RATIO                4.150 *
                       (1.26)
TOBIN_Q                 0.30 ***
                       (2.37)
GRO_EMPL                0.005 *
                       (0.24)
WAG_EMP                -0.011
                      (-0.34)
COMPITIN                0.398 **
                       (1.98)
RISK                    0.028 **
                       (6.39)
INV_CAPT                0.590 ***
                       (4.52)
CASHCON                 0.171 *
                       (0.259)
LEVERAGE               -0.122 ***
                       (3.03)
OWN_CON                -0.151 ***
                     (-13.17)
INST_OWN                0.767 ***
                      (15.08)
CASHCON X RISK         (5.98)
Pseudo [R.sup.2]        0.32
Log likelihood     -1,711.60
Chi-square            735.24 ***
N                  12,896

Notes:

* significant at the 10 percent level;

** significant at the 5 percent level;

*** significant at the 1 percent level

Numbers in parentheses report the Z-statistics computed on the
bases of robust standard errors

(a) The Sample consists of 12,896 firm-year observations between
1997 and 2004. The dependent variable is 'announcement of a stock
option plan.' In panel A and B the dependent variable is defined for
the 'executive stock option plans.' It takes the value one if the
firm announces an executive stock option plan in the observation
year and zero otherwise. In panel C, and D, the dependent variable
is the 'employee stock option plan' (option plans that are targeted
towards more then 10 percent of the employees after excluding the
top five executives of the company). It takes the value one if the
firm announces an employee stock option plan in the observation year
and zero otherwise. All the independent variables are lagged one
year. To avoid the effects of outliers, all continues variables are
winsorized at the 1st-and 99th-percentiles.

TABLE 10
DETERMINANTS OF STOCK OPTION PLAN ADOPTION
(NEW STOCK OPTION PLAN ANNOUNCEMENT) (a)

Variable              Panel-A          Panel-B          Panel-C

Constant               -4.387 ***       -4.479 ***       -5.33 ***
                      (-9.48)          (-8.29)           (8.18)
CAP_SAL                 0.172            0.170 *         -0.100
                       (1.67)           (1.45)           (1.97)
SIZE                    0.119 ***        0.120 ***        0.135 ***
                       (4.19)           (4.10)           (4.22)
DIVERSIF                0.597 ***        0.596 ***        0.780 ***
                       (4.86)           (4.73)           (5.09)
RD_RATIO                6.061 ***        6.620 ***       10.82 ***
                       (2.27)           (3.93)           (3.62)
TOBIN_Q                 0.263 **         0.205            0.121
                       (1.51)           (0.70)           (0.73)
GRO_EMPL                0.002            0.002            0.007 *
                       (0.68)           (0.56)           (1.75)
WAG_EMP                -0.007            0.007           -0.040
                      (-0.22)           (0.21)          (-0.97)
COMPITIN                0.433 **         0.433 **         0.292
                       (2.14)           (2.14)           (1.20)
RISK                    0.008            0.007            0.016 *
                       (1.05)           (0.56)           (1.68)
INV_CAPT                0.757 ***        0.575 ***        1.120 ***
                       (4.50)           (4.32)           (7.25)
CASHCON                 0.107            0.177 *          0.247 *
                       (0.75)           (0.10)           (2.75)
LEVERAGE               -0.098 **        -0.099 **        -0.161 **
                       (2.33)          (-2.21)          (-2.22)
OWN_CON                -0.068 ***       -0.068 **        -0.39 ***
                     (-10.18)          (-8.96)          (-4.71)
INST_OWN                0.277 ***        0.277 ***        0.192 ***
                       (7.21)           (6.54)           (4.12)
CASHCON X RISK                           0.015
                       (0.52)                            (1.21)
Pseudo [R.sup.2]        0.15             0.16             0.14
Log likelihood     -1,899.15        -1,421.12        -1,397.41
Chi-square            593.76 ***       554.21 ***       495.30 ***
N                  12,896            2,896           12,896

Variable              Panel-D

Constant               -5.357 ***
                       (0.566)
CAP_SAL                -0.102
                      (-0.59)
SIZE                    0.134 ***
                       (4.07)
DIVERSIF                0.720 ***
                       (4.72)
RD_RATIO                9.184 ***
                       (3.75)
TOBIN_Q                 0.122
                       (0.73)
GRO_EMPL                0.006 *
                       (1.53)
WAG_EMP                -0.038
                      (-0.93)
COMPITIN                0.330 *
                       (1.37)
RISK                    0.015 *
                       (1.57)
INV_CAPT                1.126 ***
                       (6.65)
CASHCON                 0.321
                       (5.24)
LEVERAGE               -0.198 ***
                       (2.34)
OWN_CON                -0.039 ***
                      (-4.67)
INST_OWN                0.202 ***
                       (4.29)
CASHCON X RISK          0.022 *

Pseudo [R.sup.2]        0.15
Log likelihood     -1,384.89
Chi-square            502.03 ***
N                  12,896

Notes:

* significant at the 10 percent level;

** significant at the 5 percent level;

*** significant at the l percent level

Numbers in parentheses report the Z-statistics computed on the
bases of robust standard errors

(a) The Sample consists of 12,896 firm-year observations between 1997
and 2004. The dependent variable is 'first-time announcement of a stock
option plan.' In panel A and B the dependent variable defined for the
'executive  stock option plans.' It takes the value one if the firm
announces an executive stock option plan for the first time in the
observation year and zero otherwise. In panel C and D, the dependent
variable is the 'employee stock option plan' (stock option plan that
is targeted towards more then 10 percent of the employees after
excluding the top five executives of the company). It takes the
value one if the firm announces an employee stock option plan for the
first time in the observation year and zero otherwise. All the
independent variables are lagged one year. To avoid the effects of
outliers, all continues variables are winsorized at the 1st- and
99th-percentiles.

FIGURE 1
NUMBER OF COMPANIES USING STOCK OPTION BASED COMPENSATION IN JAPAN
A CROSS DIFFERENT YEARS

Years    Number of companies using stock options

1997    141
1998    148
1999    412
2000    465
2001    550
2002    591
2003    608
2004    708

Source: 'Daiwa Securities' (http://www.daiwasmbc.co.jp/index.html).

Note: Table made from bar graph.
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Author:Hassan, Hamid; Hoshino, Yasuo
Publication:Journal of Financial Management & Analysis
Article Type:Report
Date:Jul 1, 2008
Words:16493
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