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Lecture 7

BU457 Lecture 7: Employee Stock Options

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Wilfrid Laurier University
Bixia Xu

Employee Stock Options • Employee stock options (ESOs) is where economic consequences have been particularly apparent • ESO – stock options issued to management and, in some cases, to other employees, giving them the right to buy company stock over some time period • Grant date: the date when the option was granted to the employee • Intrinsic value: difference between the exercise/strike price of the option and the market value on grant date • Most companies granted stock options where the strike price was equal to the market value on the grant date, which meant that intrinsic value was zero • Since companies were required to record an expense equal to the intrinsic value, firms did not have to record any expenses (since it is zero) but this understates the firm’s compensation cost and overstates its net income o A lack of earnings comparability across firms results, since different firms have different proportions of options in their total compensation packages • One of the reasons why fair value accounting was not adopted for ESOs was because the difficulty of establishing its value • The new draft of the proposed standard required firms to record compensation expense based on the fair value at grant date of ESOs issued during the period, which could be determined by Black/Scholes model or other pricing formula o This was heavily opposed by business owners, as they claimed consequences of lower reported profits included lower share prices, higher cost of capital, a shortage of managerial talent, and inadequate manager and employee motivation • Unlike other costs, ESOs do not require cash a cash outlay from the firm, but the cost is borne by the firm’s existing shareholders through dilution of their proportionate interests in the firm • By making some simplifying assumptions (including no dividends, no motivational impact), Huddart showed that the Black/Scholes formula, assuming ESOs held to expiry date, does indeed overstate fair value of an ESO at the grant date o The expected return from holding an option exceeds the expected return on the underlying share because share price can fall below the option’s exercise price but option cannot be worth less than zero o The “upside potential” of an American (its propensity to increase in value) increases with the time to maturity due to longer time meaning greater the likelihood that during this interval the underlying share price will take off o If an option is “deep-in-the-money”, the set of possible payoffs from holding the option and their probabilities closely resembles the set of payoffs and probabilities from holding the underlying share (i.e. payof
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