To: Prof. Chalmers From: Travis Ramme and Meghan Smith Date: April 26th, 2007 Re: Ms. Chalmers’ Compensation Choices 1. Ignoring taxation and other constraints, Ms. Jameson is better off taking the options. The stock currently trading at $18. 75 and the exercise price is $35. This may seem drastically far away. However, 5 year T-Bill rates are currently at 6. 02%. Combined with a current stock volatility of approximately 42%, this allows each option to be valued at approximately $4. 93. At this amount, Ms. Jameson’s options would be presently worth $14,790 were she to sell them.
Where she to hold them instead, Ms. Jameson’s potential upside is limitless. Her possible gains would be equal to her number of options multiplied by the difference between the stock price and her exercise price of $35, assuming that the stock price is higher than $35. There is risk involved, however. If Ms. Jameson decides to hold onto the options and not sell them, it would be possible for her to earn nothing. If the stocks price where to stay below $35 dollars, Ms. Jameson’s options would be worth nothing.
Comparatively, the $5000 cash bonus, where it to be invested over the 5 years at the risk free rate of 6. 02%, would yield only $6697. 44. 2. If Ms. Jameson was not allowed to sell her options before the allotted 5 years, the choice to take the options would have much more inherent risk. The current value of the options is derived from their market value. This market value means nothing if Ms. Jameson cannot sell the options. If this where the case, Ms. Jameson’s potential profits would be created solely by the Telstar stock rising to a price that was greater than $35 by the end of 5 years.
In fact, to equal the $6697. 44 value of the bonus she could have chosen instead, the stock would have to reach a price of at least $37. 23. This value would allow the 3000 options to be exercised for a profit of $6697. 44. This, however, is ignoring the fact that Ms. Jameson would have to pay taxes and transaction fees. If Ms. Jameson was not allowed to sell her options, she should choose the $5000 up front bonus. It represents a less risky asset. 3. Companies are often inclined to use stock options to compensate employees rather than exhausting cash flow.
It does not directly cost a company anything in terms of “accounting costs. ” There is, however, an implied economic cost equal to that of outside investors’ costs. The cost of a stock option is more or less a perceived cost, as the true value is not concrete and is virtually unknown at the time of issuance. This is due to the length of the option and specified strike price being of possible value at expiration date. The current value of an option is dependent on the performance of the company and its stock price, that is, in the future.
Executive stock options help align an executive employee’s monetary compensation with both individual performance and the overall performance of the firm. In this sense, an executive is encouraged to act in the best interests of the firm and to also to take some risks to grow the company in which they work for and thus, increase the company’s stock prices. Stock options are an effective way to correlate performance and compensation, but mainly only for employees that are in positions that can have an affect on the company’s performance.
Employees in executive, decision-making positions have the ability to impact the profitability and growth of the organization, whereas administrative assistant positions would not be as likely to improve performance due to being compensated with stock options. Companies could better individualize compensation packages for different positions. Executive positions fit the stock options benefit plan while administrative assistants may prefer stock purchasing rights rather than options.
Other employees that fall somewhere in the middle would be better suited for a combination of monetary compensation, stock options and stock in the firm. In addition, stock options with a lessened length of time to the expiration date may prove to drive option-holding employees to set short-term, achievable goals. Employees would be given successive stock options to promote their care for the company without feeling as though they are being forced to stay with the organization. This set up of granting stock options would also help to encourage performance of employees to lead to both the short and long term success of the firm. . If Ms. Jameson decided that the option was a better deal, but was concerned with being too committed and reliant on the fortunes of Telstar, she could modify her compensation package to better suit her individual needs. Ms. Jameson would be taking considerable risk by keeping all of her bonus in Telstar for stock options with such a lengthy expiration date and also due to the historical data of Telstar showing that only stock prices reached $35 (the exercise price) only once.
Instead of holding on to all 3,000 issued stock options, Ms. Jameson could keep a portion of the stock options and trade some in the market. Keeping some Telstar stock options would help keep her tied to the company without making her feel that she is bound to the company for the next five years or that she is facing enormous risk of losing her bonus altogether. By doing this, Ms. Jameson would provide herself with the opportunity to make investments outside of Telstar, and thus, better diversify her investments.