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Sally Jameson Case

The main objective of the case is to find out the value of the 3000 stock options offered to Sally Jameson and compare them to the fixed cash offer of \$5000. For this we can use the option price calculator provided at http://www.option-price.com/ The parameters required by the option price calculator are as follows: 1. 2. 3. 4. Underlying price: This is \$18.75 (the current price of the stock) Exercise price: This is \$35 (also known as the strike price of the option) Days until expiration: This is given as 5 years (calculate the number of days) Interest rate: This refers to the risk free interest rate which can be found Exhibit 4 for five years t bills 5. Dividend yield: This is given as zero 6. Volatility: This is not known and has to be estimated 7. Rounding: This simply determines the rounding off of the answer So the main challenge in this problem is to identify the "volatility" of the Telstar stock. There are two ways to do this... 1. In Exhibit 3 the volatility of the Telstar stock has been given over the past few years. This gives you an estimate that the volatility can range between a minimum of 20% to a maximum of 80%. But most of the time, the volatility fluctuates between 20% and 40%. 2. Another way to get the volatility is to calculate the "implied volatility" of stock by the price of the publicly traded telstar stock options. For this click on the tab saying "implied volatility" on the website. Here all the variables are the same as in the option calculator except for the fact that instead of volatility, you have "market price" (which is the price at which the option is traded. For this you can use the second part of Exhibit 1 where the price of three long term market traded options (similar to the employee stock option) are given. The days to expiry here will be from May 27th 1992 to Jan 22 1994. Thus by plugging in these values you will get three estimates of implied volatility. Based on both the above methods, you should now have a range of volatilities for the Telstar stock. Using the option calculator (mentioned in the beginning of this note), plug in the various values of the volatility and see the price of the "call option" (this can be seen on the website under the heading "outputs"/"call option"/"theoretical price." This shows the price of one option. Since Sally is being offered 3000 such options, the value of her grant is the price of one option X 3000. So now you essentially get a range of grant values for different volatilities. Now based on your judgment and the pros and the cons of options vs ready cash think of the arguments in favor of or against Sally selection the option grant over the ready cash.

Sally has the following two choices before her: Choice 1: To accept a taxable cash bonus of \$5000 Choice 2: To accept 3000 options at exercise price of \$35 and vesting period of five years. Choice 1: After five years, the cash bonus (invested in Treasury bill) will amount to a net gain of \$ 3816.72 at 28% tax rate as shown below:
Amount (\$) 5000 6.02% 5301 3816.72

Cash Bonus Interest Rate Cash after 5 years Net Cash after tax deducted

Choice 2: To calculate the value of options, implied volatility has been calculated as shown below using the website www.option-price.com :
Option price 7.75 4.62 3.75 Exercise price 12.5 17.5 20 Implied volatility 39.30% 37% 39.19%

To determine the option value, different values of volatility from Exhibit 3 have also been considered. Using Black-Scholes Model, the following grant values were calculated:
Volatility 20% 30% 37% 39.19% 39.30% 40% 50% 60% 80% Option Price 1.336 3.588 4.092 4.458 4.476 4.593 6.236 7.807 10.637 Grant Value 4008 10764 12276 13374 13428 13779 18708 23421 31911 Net Value after Tax deductions 2885.76 7750.08 8838.72 9629.28 9668.16 9920.88 13469.76 16863.12 22975.92

*the tax rate was taken as 28%.

As seen from the above calculations, the grant value is higher than the net receivable cash bonus for every volatility rate apart from 20%. This implies that for high volatilities the option value will be such that the net grant value would be higher than the net cash receivable. But these values are notional figures that need to be validated by past data. Considering the historical data as found in Exhibit 2 and Exhibit 3, it is also observed that: 1. Stock price touched \$35 only in the year 1989 in the past ten years and currently is at a price of \$18.75. A steep increase in the stock price above \$35 is very unlikely in future. For Sally to benefit from the options, the stock price must be above \$35 and to benefit more than the return from the cash bonus after 5 years the required stock price must be at least \$36.27 as shown below:
Break Even Net Cash after tax deduction # of Shares Required Profit per share Required Stock Price

3816.72 3000 1.27224 36.27224

2. Volatility represents the market fluctuations- upward and downward. Comparing Exhibit 2 and Exhibit 3, it is seen that in 1988 a high volatility of above 80% corresponded to a severe dip in the stock price from \$34 to \$17 (approx). Thus, it cant be concluded that high volatility will necessarily represent a high performing stock. 3. Hence, we conclude that Sally should accept the cash bonus instead of the options considering the companys part record and high risk associated with the options as represented by the high volatilities. Also, if she is likely to leave before the vesting period of five years, then the pay off from the option will be zero and hence cash bonus would be a better choice.

Homework Exercises on Options

Analysis of Different Option Schemes Current Market Price: Rs.1000 Expected Market Price at the end of 1st Year: Rs.1250 Expected Market Price at the end of 2nd Year: Rs.1500 Expected Market Price at the end of 3rd Year: Rs.1750 Option Value: 0.25 * Exercise Price Part a) In all the three cases, two situations have been considered: 1. Options are exercised at the end of the vesting period 2. Options are exercised only at the end of the 3rd year A. Fixed Value Plan: Pay off on each option if exercised at the end the 3rd year 750 500 250 Total sum if all options exercised only at the end of 3 years: Corresponding Individual PayOffs Rs. 3,000,000 Rs. 1,600,000 Rs. 666,667 Rs. 5,266,667

Year No 1 2 3

Grant value 1000000 1000000 1000000

Market price at the Exercise Price end of the year 1000 1250 1500 1250 1500 1750

No. of options 4000.00 3200.00 2666.67

Yearly Pay off on each option 250 250 250 Total sum:

Total yearly payoff Rs. Rs. Rs. Rs. 1,000,000 800,000 666,667 2,466,667

ear o 1 2 3

250 250 250 T o ta l s u m :

R s. R s. R s. R s.

T o ta l s u m if a ll o p tio n s 3 ,0 0 0 ,0 0 0 e x e rc is e d o n ly a t th e e n d o f R s . 3 y e a rs :

6 ,0 0 0 ,0 0 0

x e rc is e r ic e

o o f o p tio n s

a y o ff o n e a c h o p tio n

T o ta l y e a rly p a y o ff

C. Mega Grant Plan

Market price at the end of the year 1250 1500 1750 Pay off on each option 250 500 750 Total sum: Total yearly payoff Rs. Rs. Rs. Rs. Pay off on each option if exercised at the end the 3rd year 1,000,000 750 2,000,000 750 3,000,000 750 Corresponding Individual PayOffs Rs. 3,000,000 Rs. 3,000,000 Rs. 3,000,000 9,000,000

Year No 1 2 3

No. of options 4000 4000 4000

Total sum if all options 6,000,000 exercised only at the end of Rs. 3 years:

Considering that the stock performs as per expectations, the Mega Grant Plan would give the maximum pay off and hence is the best plan. Part b) If the stock prices are expected to fall in the next three years as shown below, then the option will not be exercised resulting in zero pay off for each year. In such a scenario, Fixed Value Plan will be preferred as the number of options increases each year thereby accumulating the highest number of options by the end of the third year. In spite of the falling market prices, the total grant value is consistent throughout the three years. Mega Grant Plan will only be beneficial if the stocks are re-priced, a situation that has not been considered in this analysis. Fixed Value Plan

Year N o 1 2 3

Fixed Number Plan

M a rke t p rice a t th e e n d o f th e y e a r 750 500 250

Year No 1 2 3

1 2 3

Year N

E ercise rice

N . f

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