Chapter 6
Financial Options
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
6-1 See the BOC model. Based on the Black-Scholes model, we see that the value of the
option increases with the stock price, time to expiration, variance, and the risk-free rate.
The option value declines with increases in the strike price.
6-2 As discussed in the chapter, options are compensation, compensation is an expense,
and expenses should be deducted from revenues when calculating income. Therefore,
options should be deducted on the income statement. However, if options are to be
expensed, their values must be estimated. Although it may not provide an exactly precise
estimate of the “true” value of an option, the Black-Scholes model can give us a
reasonably good estimate of the option’s value, and that estimate can be used both to let
employees know what they are getting when they are granted options and also for purposes
of expensing options. Companies need to provide some specific level of compensation,
and total compensation might consist of regular salary, a cash bonus for targeted
performance levels, and stock options. The value of the options must be estimated if a
rational compensation package is to be established.
High tech companies have made the greatest use of options. The companies benefited from
reduced cash requirements during their rapid growth phase, and many employees of
successful companies became millionaires. However, options produced problems in the
period 2000-2002, when stock prices fell sharply, driving down the values of options
awarded in earlier years. The stock collapses were due primarily to a general decline in the
market from its “bubble” high, not by poor employee performance. If an employee had
received options whose value was based on an unrealistically high stock price, and if that
price later declined sharply, then it could be argued that his or her “true” past
compensation was too low. Should the company now re-price its outstanding options,
lowering the strike price so as to make the options valuable and thus provide the expected
level of total compensation? And, if options are re-priced, is this fair to stockholders, who
don’t get any comparable treatment? This is an issue that many companies are currently
struggling with today.
It’s interesting to note that in 2003 Warren Buffett had Berkshire Hathaway expense
options, and he hired two Wall Street firms to find a value of the options. It turned out that
their values were consistent with Black-Scholes, indicating that even investment banking
firms value options with Black-Scholes. It appears that Buffet will give up on trying to
improve on Black-Scholes and will simply use it. We agree.
6-3 In the past, managers and boards of directors have viewed stock options and stock
grants as almost “free” in the sense that they required no cash outlay, and they didn’t
appear as expenses (albeit non-cash) on the income statement. This view was common
even though it is abundantly clear from a finance perspective that such compensation is
costly—it dilutes the existing shareholders’ ownership and so the existing stockholders are
certainly paying for it. There’s no such thing as a free lunch! Now, with the adoption of the
FASB’s statement 123R requiring the expensing of stock options, their economic cost will
appear as an expense on the income statement, even if they still require no cash outlay.
Given that equity based compensation really does cost the shareholders something, it then
matters what the most cost-efficient way is to provide incentives to employees.
Suppose the current stock price is $40 and you would like to provide a dollar benefit for
each dollar increase in the stock price over the next 5 years. Awarding stock would cost
$40 per share. If, instead, you granted a stock option with an exercise price of $40 and 5
years to expiration, then this option would be worth $15. And if the exercise price were
higher, say $50, then the option would be worth only about $10. So the economic cost of
awarding a 5-year stock option is only 20% to 40% as much as awarding stock. So stock
options are cheaper than stock.
However, stock options and the stock itself don’t have the same payoffs. If the company
does badly, and the stock declines to $30, then the stock option simply doesn’t pay off and
the employee receives nothing—stock options are designed to only pay off when the
company does better. However the stock itself will still be worth $30 and so the employee
will still have some “value” in the incentive package. And if the stock declines further, this
value will decline as well. So if management wants to make employees share in the upside
benefits, but not participate in the downside costs of stock performance, then stock options
are an appropriate incentive vehicle. However, if management wants employees to be
exposed to risk that the company might do badly, then stock is a better choice.
All of this is made more complicated by how stock options and stock grants are taxed. The
tax intricacies are beyond the scope of this text, but they are important as well.
6-4 If managers or stockholders view their stakes as option-like, then they have some very
clear incentives. You know from problem 1 above that options are worth more the higher
the value of the underlying asset, the more volatile the underlying asset and the longer the
time to expiration. Thus managers will have incentives to 1) increase the value of the
