 Another problem that can be faced while designing the incentive system is the use of stock options. We know that stock options are the rights given to the management of the firm so that their individual objectives can be well aligned with the firm's overall objective. And the firm's overall objective is the shareholders wealth maximization. Stock options are basically the long term compensation contracts that are closely tied with the management performance. Stock options are the rights given to the management to acquire a specified number of shares at a specified price at a specified date. The price at which the right is given to the management is known as the exercise price. A benefit of this transaction is that it carries little consequences of taxation. Means, at the inception of the grant, neither the company nor the manager is required to pay any tax thereon. And when the manager exercises his right to acquire the stock, he has to pay tax on the difference between the stock value and the exercise price. The question arises why a firm go for stock option? An answer to this question is that a manager's salary augmented with the stock option as a whole and comprehensive compensation can be easily aligned with the shareholders wealth maximization objective. Also, this transaction is ex-efficient for both the firm and the management. Giving stock options to the management encourages management to take risky projects who carry the positive net present value. And if these risky projects yield a positive net present value, the shareholders value can be increased or there is a value creation. Also, the firm's shareholders see this transaction as a net benefit for themselves. There are certain drawbacks with this stock option. Sometime, the management has to take decision on some risky projects. But as the project is assessed at a risky project, the management may expect higher amount of compensation. Also, this expectation of higher amount of compensation may lower the benefit for the shareholders whose underinvestment has been reduced. Further, the stock options without dividend are not much attractive for the management. So, the management may go for the shares repurchase agreements. In the last, as we know, that share has a market value. So, the management can go for some biased managerial decisions whose implication will be the variation in the share market prices. And as a result, some gain will be there in the pockets of the management. There are three hypotheses in the favor of stock options. The first hypothesis is the incentive hypothesis. This is that market favors the incentive as the plan carries benefit, which are in excess of its cost. The example can be taken that let's assume the shareholders see a huge increase in the market value of their share holdings. Let's assume it is 100 million rupees. Now, we know that a certain amount of shares will also go to the management as a stock option. Now, let's assume the market value of these stock options is rupees 5 million. Now, shareholders are gaining a market value of 100 million at a cost of 5 million. So, net benefit is 95 million rupees, which is an incentive for the shareholders on this transaction. The second hypothesis is the signaling hypothesis. This says that the management with superior information about future prospects of the company may create a favorable market situation for the company's share. And as a result, the prices of their shares may go on the increase. The final is the tax hypothesis. This says that more after-tax payoffs on the option plan are than the bonus plans. Managers can be given either the bonus in addition to the salary or they may be given stock options in addition to the salary. Now, the tax differential as a favorable amount can be achieved on the stock option than the bonus. There is another problem with the stock options that management can play itself with the stock. How management can play? Let's say that if the management have a sizable amount of shares with a heavy market value, then the management can go for such managerial decisions that can invariably be responsible for variation in the market. And in doing so, the management can reap a huge amount of gain in their stock value. This gives an opportunity to the management to sell their shares at the higher prices. But such management practices can be prevented by the management of the firm through certain measures. Like the management can be offered shares during a certain period of time where the manager cannot play in the market. And another step can be taken if the management has earned a certain amount of gain. Again, the company through its charter can empower its board of directors to get back the gains reaped by the management.