CHAPTER 14
EMPLOYEE STOCK OPTIONS AND VALUATION
LEARNING OBJECTIVES
1. What stock options are and why they are valuable.
2. How the Black-Scholes option-pricing formula works.
3. Why companies grant employee stock options.
4. How employee stock options differ from publicly traded options.
5. How the financial reporting for employee stock options works.
6. How the employee stock options affect income taxes.
7. How to generalize valuation theory to deal with employee stock options.
TRUE/FALSE QUESTIONS
1. The reason analysts are interested in employee stock options is because firms that give employees stock options may have to sell its stock for less than its market value at some point in the future.
(easy, L.O. 1, Section 1, true)
2. Employee stock options are always put options, not call options.
(moderate, L.O. 1, Section 1, false)
3. When the strike price of an option is less than the market value of the stock, the amount of the difference is the intrinsic value of the option.
(moderate, L.O. 1, Section 1, true)
4. The Black-Scholes option-pricing formula was one of the most important breakthroughs in finance.
(moderate, L.O. 2, Section 1, true)
5. Holding stock options cause employees to behave more like shareholders.
(moderate, L.O. 3, Section 2, true)
6. Recent academic research shows that an analyst using Black-Scholes can adapt the formula for ESOs by replacing the actual time to expiration (t) with the expected time the option will be held.
(difficult, L.O. 3, Section 2, true)
7. Most firms follow the intuitive value method of accounting for ESOs.
(moderate, L.O. 4, Section 3, false)
8. Since the FASB has released SFAS No. 123, “Accounting for Stock-Based Compensation,” firms now recognize ESO costs and no longer use APB Opinion No. 25 for guidance in this area.
(difficult, L.O. 5, Section 3, false)
9. Analysts who believe earnings should reflect ESO costs might view a firm’s use of APB Opinion No. 25 as a manipulation of earnings.
(moderate, L.O. 5, Section 3, true)
10. The classification of ESOs as ISOs or NSOs determines whether a firm gets a tax deduction when the ESO is exercised.
(moderate, L.O. 6, Section 3, true)
11. Although a firm may not recognize any expense in its income statement for an ESO, the option may generate income tax savings through tax deductions, and so the savings is credited directly to equity.
(moderate, L.O. 6, Section 3, true)
12. An analyst can incorporate ESOs in the valuation by considering outstanding ESOs to be free cash flow equivalents and expected ESO grants to be capital claims.
(difficult, L.O. 7, Section 4, false)
13. Not all ESOs generate a tax deduction for the firm.
(moderate, L.O. 7, Section 4, true)
14. An option-pricing model can be used to determine the value of yet-to-be-granted ESOs.
(moderate, L.O. 7, Section 4, false)
15. Under the residual income model, charges for ESO will be reflected in the net operating profit after taxes (NOPAT).
(moderate, L.O. 7, Section 4, false)
MULTIPLE CHOICE QUESTIONS
16. A stock option which gives the option holder the right, but not the obligation, to purchase shares of a firm’s stock at a fixed price is also known as a:
a. mutual equity option
b. put option
c. stock rights option
d. call option
(easy, L.O. 1, Section 1, d)
17. The option ______is the individual who possesses the right to buy stock from the option ______at the ______price.
a. writer; holder; strike
b. buyer; seller; market
c. holder; broker; average market
d. holder; writer; strike
(moderate, L.O. 1, Section 1, d)
18. Thousands of different stock options are traded. The exchange charged with trading these options is known as the:
a. CBOE
b. NASDAQ
c. NYSE
d. DOW
(moderate, L.O. 1, Section 1, a)
19. The amount by which the market value of the stock exceeds the option strike price is known as the:
a. amount the option is out of the money
b. option premium
c. amount the option is in the money
d. extrinsic value of the exercised option
(moderate, L.O. 1, Section 1, c)
20. When a strike price and stock price are equal, the option is:
a. in the money
b. at the money
c. out of the money
d. at its option premium
(easy, L.O. 2, Section 1, b)
21. The Black-Scholes option-pricing formula demonstrates how option values vary with stock price. If an option is very far out of the money the:
a. option value and stock price are equal
b. option value increases nearly dollar-for-dollar with stock price
c. increase in option value is very small as the price of the stock decreases
d. increase in option value is very small as the price of the stock increases
(difficult, L.O. 2, Section 1, d)
22. The Black-Scholes option-pricing formula demonstrates how option values vary with stock price. If an option is very far in the money the:
a. option value increases nearly dollar-for-dollar with stock price
b. increase in option value is very small as the price of the stock decreases
c. increase in option value is very small as the price of the stock increases
d. option value and stock price are equal
(difficult, L.O. 2, Section 1, a)
23. The Black-Scholes option-pricing formula demonstrates how option values vary with stock price. When call options are calculated using the formula C = S · N(d1) – X · exp(- r · t) · N(d2), the term X represents:
a. per share value of the firm’s stock
b. cumulative normal distribution function
c. strike price
d. None of the above answers are correct.
(difficult, L.O. 2, Section 1, c)
24. Employee stock options (ESOs) differ from publicly traded options because ESOs are subject to restrictions that do not apply to publicly traded options. Which of the following statements is false regarding the typical restrictions placed on ESOs by firms?
a. Employees may not sell ESOs.
b. Employees generally can hedge ESOs.
c. Employees cannot buy ESOs.
d. ESOs are exercisable after the employee has remained with the firm through a vesting period.
(moderate, L.O. 3, Section 2, b)
25. How do employee stock options (ESOs) differ from publicly traded options?
a. ESOs are generally worth more than similar publicly traded options.
b. Employer firms are responsible for ESOs.
c. ESOs have certain restrictions placed on them.
d. Answers b and c are both correct.
(moderate, L.O. 4, Section 2, d)
26. The use of employee stock options has grown tremendously in the last decade. The growth has caused consultants and financial advisors to take a serious interest in analyzing the effects of stock options. The consulting firm Watson Wyatt Worldwide has devised a measure of stock option use called stock option overhang. Stock option overhang is defined as:
a. stock options granted by a firm plus those remaining to be granted, as a percentage of the total number of shares outstanding
b. stock options exercised by employees of a firm plus those remaining to be granted, as a percentage of the total number of shares outstanding
c. stock options actually granted by a firm less those remaining to be granted, as a percentage of the total number of shares outstanding
d. None of the above answers are correct.
(moderate, L.O. 4, Section 2, a)
27. The identity of the option writer plays an important role when comparing ESOs with publicly traded options. In exercising an ESO, the firm acts as option writer. This has an effect on the firm’s stock because:
a. ESOs that are exercised dilute the other shareholders’ ownership
b. the firm must sell its own stock at less than fair value
c. Answers a and b are both correct.
d. ESOs add to the value of the firm’s stock
(moderate, L.O. 4, Section 2, c)
28. A firm that follows the intrinsic value method of accounting for ESOs must, at the time an option is exercised, recognize:
a. no cost
b. that there is a direct effect on the value of the firm’s stock
c. the amount the option is in the money
d. the amount the option is out of the money
(moderate, L.O. 4, Section 3, c)
29. The current status of the provisions of SFAS No. 123 are:
a. mandatory
b. voluntary, although firms must make footnote disclosure if still following APB Opinion No. 25
c. irrelevant since all firms currently follow APB Opinion No. 25
d. None of the above answers are correct.
(moderate, L.O. 4, Section 3, b)
30. Income tax law recognizes several types of ESOs. An option that is not in the money when granted and the stock employees receive when the option is exercised is retained by the employees for at least one year is known as:
a. a nonqualified stock option
b. an incentive stock option
c. a publicly traded option
d. None of the answers above are correct.
(moderate, L.O. 5, Section 3, b)
31. Employees holding an incentive stock option (ISO) may receive favorable tax treatment over nonqualified stock option (NSO). When a disqualifying disposition occurs,
a. the option is at the money
b. the strike price of the ESO changes
c. the option was not in the money when granted
d. an ISO will be treated as an NSO for tax purposes
(moderate, L.O. 5, Section 3, d)
32. Regarding ESOs that are exercised, a firm will be entitled to a tax deduction:
a. when the option is an NSO or a disqualifying disposition occurs
b. only when a disqualifying disposition occurs
c. when the option is an ISO
d. when the option is publicly traded
(moderate, L.O. 6, Section 3, a)
33. For an analyst to incorporate ESOs into a valuation, the analyst must:
a. All of the answers below are correct.
b. forecast yet-to-be-granted ESOs
c. estimate the value of outstanding ESOs
d. estimate the marginal tax rate on ESOs
(moderate, L.O. 7, Section 4, a)
34. Firms may receive a tax deduction for NSOs and ISOs with disqualifying dispositions. The analyst can estimate the historical value of the tax rate used for this tax deduction by calculating a ratio. The denominator used for this ratio is:
a. None of the answers below are correct.
b. the tax benefit generated by ESO exercises in the future
c. the estimate of what the tax deduction would be if all options were NSOs or ISOs with disqualifying dispositions
d. the amount of tax benefits received by the firm
(difficult, L.O. 7, Section 4, c)
35. The analyst valuing outstanding ESOs in a free cash flow model:
a. must use simultaneous equations and solve for the value of ESOs and the firm’s equity algebraically
b. must use a numerical search technique to solve for the value of ESOs and the firm’s equity since it cannot be done algebraically
c. can use the standard Black-Scholes formula to solve for both the value of the ESOs and the firm’s equity
d. The analyst could use any of the approaches listed above.
(difficult, L.O. 7, Section 4, b)
ESSAYS
36. Comment on the differences between publicly traded options and ESOs.
Suggested solution:
Employee stock options (ESOs) and publicly traded options differ in two important ways. First, ESOs are subject to a number of restrictions that are not placed on publicly traded options. Second, the option writer of an ESO is the employer firm, whereas the option writer of a publicly traded option is usually an independent third party to the firm and the option holder.
Employees cannot buy ESOs. Many firms give employees ESOs as part of their compensation package. ESOs are also given to employees to encourage them to behave more like shareholders, since they have a vested equity interest in the firm. Publicly traded options can be purchased or sold by the general public on an open exchange such as the Chicago Board Options Exchange (CBOE).
Firms place restrictions on ESO that are not placed on publicly traded options. Typical restrictions include:
· Employees may not sell ESOs
· Employees may not hedge their options
· ESOs are generally not exercisable until an employee has remained with a company through a vesting period
The restrictions placed on ESOs make them different than a typical publicly traded option and reduce their value when compared to a similar publicly traded option. This is because of the possibility of a forfeiture of the option (if the employee leaves the firm’s employ before becoming fully vested). Also, the early exercise of the option by the employee will prevent a build-up of option premium and cause it to be worth less than similar publicly traded options.
(moderate, L.O. 4, Section 2)
37. Explain the tax treatment of ESOs and its impact on a valuation.
Suggested solution:
The tax treatment of ESOs is important because any tax deduction related to ESOs that a firm receives will reduce the cost of the ESOs. This is complicated by the fact that the tax deduction for ESOs depends on the characteristics of the options.
Under current tax law, two types of ESOs are recognized. ESOs are classified as ISOs (known as incentive stock options) and NSOs (known as nonqualified stock options). ISOs provide employees with tax-favored treatment (subject to certain rules), whereas NSOs do not.
An option must meet certain requirements to be considered an ISO. First, it must not be in the money when it is granted. Second, employees who exercise ISOs must retain the stock issued to them for at least one year after exercise for the employee to receive favorable tax treatment. If an employee sells the stock within the one-year period, a disqualifying disposition occurs, which means the ISO turns into an NSO and the employee loses the favorable tax treatment granted to the ISO status.
A firm will receive a tax deduction for NSOs and for disqualifying dispositions from ISOs. It will not receive any tax deduction for an ISO that does not become a disqualifying disposition within the one-year stock retention period.
(moderate, L.O. 6, Section 3)
38. Discuss the problems ESOs present when preparing a cash flow valuation for a firm.