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Lecture 3

COMM 122 Lecture 3: HW 3 Assignment v2

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COMM 122
Evan Dudley

MINI CASE – MOONLIGHT INC. You have just been hired as a financial analyst by Moonlight Inc., a mid-sized Ontario company that specializes in creating exotic clothing. The company went public last year. The hiring committee (not all of themknowmuchaboutEmployeeStockOptions(ESO))has given you the task to make recommendations on the compensation package to be offered to an incoming senior executive. One of the major concerns is about granting employee stock options in the compensation package. Some members of the compensation committee are worried that such a grant will create incentives to maximize short-term profits at the expense of long-term growth. Other members are concerned that granting employee stock options may dilute current shareholders’ ownership stakes in the company. Along with a base salary, the executive will receive options with a strike price of $75 for 10,000 shares of company stock and a vesting period of 2 years. The options mature in five years. If the executive leaves the company after the options vest, he must exercise within 60 days or forfeit. When you examine the factors that affectthepriceof anoption,allofthefactorsexceptthe standard deviation (volatility) of the stock are directly observable in the market. The risk-free rate is 6 percent, and the current stock price of Moonlight Inc. stock is $75. Since the company is relatively new, there is not enough historical stock price data to accurately estimate the volatility of the company’s stock. However, similar established companies have an annual average standard deviation of 48%. Based on the information provided above and concepts learnt in Chapters 23 and 24, answer the following questions. 1. What is a financial option? 2. Why do you suppose employee stock options usually have a vesting provision? Why must they be exercised shortly after you depart the company even after they vest? 3. In 1973, Fischer Black and Myron Scholes developed the Black-Scholes Option Pricing Model (B-S formula). What assumptions underlie the B-S formula? 4. Using the information provided above, compute the following: a. The intrinsic value of t
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