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
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
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.
Year No 1 2 3
Market price at the Exercise Price end of the year 1000 1250 1500 1250 1500 1750
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
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
Year No 1 2 3
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
Year No 1 2 3
1 2 3
Year N
E ercise rice
N . f
tions