Sally-Jameson---Valuing-Stock-Options-in-a-Compens

SallyJameson:ValuingStockOptionsinaCompensationPackageByGroup101.IfweignoretaxconsiderationandassumethatSallyJamesonisfreetosellheroptionsatanytimeaftershejoinsTelstar,whichcompensationpackageisworthmore?Firstscenario,ifSallychoosesstockoptionsandholduntilmaturitydate.Ignoringthetaxationandotherconstraints,thefuturevalueofcashcompensationattheendofthe5thyearwillbe5000*(1+0.0602)^5=6697.44.Wecaneasilyformtheequation3000*(P–35)=6697.44,wherePisthefuturestockpriceofTelstar,sothestockpricemustincreasetoatleast37.23attheendof5thyeartogetthesameamountofthecashcompensationandifthestockpricewheretostaybelow35,Sally’optionwouldbeworthnothing.Thestock,whichpaysnodividendandisnotexpectedtopayoneintheforeseeablefuture,istradingat18.75.Itseemssignificantdifferencebetweentheexercisepriceandthespotprice.AsshowninExhibit2,Telstarstockpricehasincreasedhigherthan$35onlyonceand10-yearaveragestockpriceisaround20.Therefore,thechancethatthevalueofoptionisgreaterthanthecashcompensationisveryrare.Secondscenario,assumeSallyisfreetoselloptionsatanytimeafterherjoiningTelstar,shemaysellheroptionimmediatelyafterreceiving.ThenwetrytopricethevalueofstockoptionbyusingBlack-ScholesModel.Weknowthatthestockiscurrentlytradingat$18.75andtheexercisepriceis$35.Wetakethe5yearT-billrate6.02%astheriskfreerate.FromtheExhibit2,wecancalculatethevolatilityofTelstarstockreturnisaround27.65%.Plugthemintotheformula,thecalloptionpricewillbe2.53.Atthisamount,Sally’soptionswouldbepresentlyworth2.53*3000=7590.Sheisbetterofftakingtheoption.2.Howshouldwefactorinthecomplicationsignoredinquestion1?HowwouldtheyaffectthevalueoftheoptiontoMs.Jameson?Whatshouldshedo?Why?Inconsideringtaxes,transactioncostsanddifficultyofoptionliquidity,weconcludethatcashpackageisworthmorethanstockoptionpackageandtherefore,itissuggestedthatSallychoosecashpackage.Thetaximpactcalculation:TakingaccountofthecalculationaboveandfollowinguncertaintiesthatexistifSallyselectsstockoption,weconsideritisbetterforhertochoosesigningbonus.ThelikelihoodthatstockpriceexceedsUSD37.28islow.Fromtheexhibit2,wenotethatceilingofTelstarCommonStockseemstobenearlyUSD35.Uncertainfactorsfromthetimevalueandotherriskpointsinthefuture.IfMs.JamesonleavesTelstarduringthevestingperiod(5year),shecannotobtaintheoption.ItgivesrisetheopportunitycosttoSallythatsheSenario1：CashsigningbonusBonusa5,000Taxrateb28%Amountaftertaxc=a*(1-b)3,600Interest(equ.Riskfreerate)d6.02%Futurevaluee=c*(1+d)^4+a*d*(1+d)^44,928.64Note:taxwillbedeductedattheendofyear1.Senario2：StockoptionFuturevalue4,928.64=(FV-35)*3000*(1-28%)Priceofshare5yearlater37.28Currentstockprice18.75Growthrate98.8%=37.28/18.75-1SincetaxratecannotbeputinBlack-Scholesmodeldirectlytocalculatetheoptionpresentvalue,weusedfollowingapproachtoestimatethepotentialfutureshareprice,ifms.Jamesonwouldliketoearnthesame.Assumethatshewillholdthestockmorethan1yearandapplicabletaxrateis28%,capitalgaintaxrate.Note:IfMs.Jamesonwouldliketohaveagainequivalenttowhatsheearnsfromcashbonus(4,928),thestockpriceafterfiveyearshallatleastexceedUSD37.28/share.maynotgoforanotherbettercompanyinthevestingperiod,evenifshemaynotstayatTelstarforthatlong.3.Doesgrantingstockoptionscostcompaniesanything?Ifso,whopays?Whatincentivesdoexecutiveoptionplanscreatefortheirrecipients?Howmightfirmscreatemoreefficientoreffectiveincentives?Asearlyas2001,afterthefinancialscandalofEnron,theFASBannouncedthatthestockoptionsmustbetreatedascostsoffirms.NowboththeUSAandChinaaccountingsystemdeterminestockoptionsaslaborcostoffirms,whichbepaidbythecompanies.Itisintangible,alsocanbeseenasprobablepaytotherecipients.However,thiscostmustbeshownonthefinancialreportanddeductedfromtheincomeofthefirms.Accordingtothenatureofstockoptions,itconnectsthebenefitsofthecompaniesandtheexecutivestogetherandencouragestheexecutivestoworkhardtoboostthevalueoffirmssothattheycangetcapitalgainsviaexercisingtheoptions.Tocreatemoreefficientoreffectiveincentives,afirmcanconsidertheflowingwaysbesidesthestockoption:a.Mentalincentives.Maslow’sDemandTheorytellsusthatwhenlowerphysicalneedsbesatisfied,peopleacquiremorementalneeds.Thereforementalincentivesashumanitiesconcerncanextremelystimulatetheemployees’enthusiasm.b.Authorization.Thismethodiscommonlyoverlookedbymostfirms.Infact,itnotonlycanincreaseemployees’senseofbelongingandparticipation,butdispersetasksatnocost,whichincreasestheefficiency.Themostimportanteffectistoprovidesgooddevelopmentopportunitiestoemployeesandattracttalents.c.Training.Thispointisalsoatthementalaspect.Whentheemployees’salaryreachesacertainlevel,theyneedmoretrainingasrewards.Becausetrainingcanprovidebettercareerdevelopmentsandlaborvalue.4.WhatifMs.Jamesondecidedthattheoptionwasabetterdeal,butshedidnotwanttohaveallherfinancialwealth(aswellasherhumancapital)tiedtothefortunesofTelstar?AssumingsheworksatTelstarandacceptstheoptiongrant,isthereanythingshecoulddotountiesomeofherfinancialwealthfromTelstar?Althoughtheoptionsoundedagoodchoice,ifSallydidnotwanttohaveallherfinancialwealth(aswellasherhumancapital)tiedtothefortunesofTelstar,shehad