Explanation

Correct Answer: B - Eliminating stock grants and options from management compensation

Why this is correct:

1. Stock grants and options create risk-taking incentives: When management compensation includes equity-based components like stock grants and options, managers have incentives to take on more risk because they participate in the upside potential of the company's stock price. Options, in particular, have asymmetric payoffs - managers benefit from stock price increases but don't suffer losses from price declines (beyond the option premium).

2. Removing equity-based compensation reduces risk-taking incentives: By eliminating stock grants and options, management compensation becomes more fixed and less tied to stock price volatility. This makes managers more risk-averse because:

   • Their compensation is less dependent on uncertain future stock performance
   • They don't benefit from potential stock price appreciation from risky projects
   • They face less pressure to take risks to boost stock prices

3. Alignment with risk aversion: Risk-averse managers prefer certain outcomes over uncertain ones with potentially higher returns. Fixed compensation provides more certainty than variable, equity-based compensation.

Why the other options are incorrect:

A. Decreasing the length of management tenure:

• Shorter tenure might actually make managers MORE risk-seeking, not less
• With limited time horizons, managers might take excessive risks to achieve quick results
• This could lead to "short-termism" where managers prioritize immediate gains over long-term stability

C. Tying management compensation to the size of the company's business:

• This could encourage empire-building and expansion, which often involves taking MORE risks
• Growth-oriented compensation might lead to aggressive acquisitions, market expansion, or other risky strategies
• Size-based compensation doesn't necessarily promote risk aversion; it promotes growth at potentially higher risk levels

Key Concept: The relationship between compensation structure and managerial risk-taking behavior is a fundamental principle in corporate governance. Equity-based compensation aligns manager interests with shareholders but can encourage excessive risk-taking, while fixed compensation tends to promote more conservative, risk-averse decision-making.