Cash-rich firms are more likely to suffer from the agency problem of free cash flow. Introducing executive stock options (ESOs) into compensation scheme is expected to reduce the conflict of interests between executives and shareholders. Prior studies contend that the interest alignment mitigates the agency problem of free cash flow. However, the ESO risk incentives address the fundamental of agency problems, managerial risk aversion. We employ both incentives when examining compensation effect on decision of mergers and acquisitions (M&A) and postmerger performance to fully capture the relation. Generally, our results indicate that the M&A induced by ESO risk incentives is value-decreasing. However, subsample analyses indicate that ESO risk incentives are applicable to mitigate the agency problem of overinvestment in diversified M&A conducted by cash-rich bidders and in cash-rich firms with low investment opportunity set (IOS).

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