Properly designed incentives should reward management if and only if it succeeds in increasing shareholder wealth. We show that conventional at-the-money stock options do not achieve this objective, because they allow management to benefit from value created before the options were awarded. Consequently the cost of the options can exceed any value created for shareholders, and management can even benefit from negative-NPV projects. We also find that with at-the-money options, dividends are undesirable to management unless the strike is adjusted while repurchases are quite favorable to management. These problems are solved by indexing the exercise price to the cost of capital, a type of option that has been discussed lightly in the practitioner literature. Empirical estimates reveal that the difference in value between at-the-money options and options indexed to the cost of capital is about one-quarter percent of equity value but about 42 percent of option value and about 18 percent of total compensation. This figure is positively and significantly related to measures of free cash flow and overinvestment, as predicted by the model. If options are viewed strictly as incentives, this figure suggests a substantial waste of shareholder value, but if options are viewed as