1. If we ignore tax consideration and assume that Sally Jameson is free to sell her options at any time after she joins Telstar, which compensation package is worth more?
First scenario, if Sally chooses stock options and hold until maturity date. Ignoring the taxation and other constraints, the future value of cash compensation at the end of the 5th year will be 5000 * (1 + 0.0602) ^ 5 = 6697.44. We can easily form the equation 3000 * (P – 35) = 6697.44, where P is the future stock price of Telstar, so the stock price must increase to at least 37.
23 at the end of 5th year to get the same amount of the cash compensation and if the stock price where to stay below 35, Sally’ option would be worth nothing. The stock, which pays no dividend and is not expected to pay one in the foreseeable future, is trading at 18.75.
It seems significant difference between the exercise price and the spot price. As shown in Exhibit 2, Telstar stock price has increased higher than $35 only once and 10-year average stock price is around 20.
Therefore, the chance that the value of option is greater than the cash compensation is very rare. Second scenario, assume Sally is free to sell options at any time after her joining Telstar, she may sell her option immediately after receiving. Then we try to price the value of stock option by using Black – Scholes Model.
We know that the stock is currently trading at $18.75 and the exercise price is $35. We take the 5 year T-bill rate 6.02% as the risk free rate. From the Exhibit 2, we can calculate the volatility of Telstar stock return is around 27.65%. Plug them into the formula, the call option price will be 2.53. At this amount, Sally’s options would be presently worth 2.53 * 3000 = 7590. She is better off taking the option.
2. How should we factor in the complications ignored in question 1? How would they affect the value of the option to Ms. Jameson? What should she do? Why?
In considering taxes, transaction costs and difficulty of option liquidity, we conclude that cash package is worth more than stock option package and therefore, it is suggested that Sally choose cash package. The tax impact calculation:
Taking account of the calculation above and following uncertainties that exist if Sally selects stock option, we consider it is better for her to choose signing bonus. The likelihood that stock price exceeds USD 37.28 is low. From the exhibit 2, we note that ceiling of Telstar Common Stock seems to be nearly USD 35. Uncertain factors from the time value and other risk points in the future. If Ms. Jameson leaves Telstar during the vesting period ( salary reaches a certain level, they need more training as rewards. Because training can provide better career developments and labor value.
4. What if Ms. Jameson decided that the option was a better deal, but she did not want to have all her financial wealth (as well as her human capital) tied to the fortunes of Telstar? Assuming she works at Telstar and accepts the option grant, is there anything she could do to untie some of her financial wealth from Telstar? Although the option sounded a good choice, if Sally did not want to have all her financial wealth (as well as her human capital) tied to the fortunes of Telstar, she had better choose the cash rather than the option. Because the option was a better deal depended on a fact that the volatility was computed on the base of 10 years.
There was a very big chance that in less than 5 years or even only 1 or 2 years, the volatility would much less than the number we computed before, as the year 1988 had contributed the biggest volatility because of economy reasons. It means that the value of the option tended to be valueless in short time if the stock price happened to performance steadily. Assuming Sally works at Telstar and accepts the option grant, she can sell some of her options when the price exceed 5000/3000=1.67 or execute some of her options when the stock price is above $35. Sally could keep a portion of the stock options and trade some in the market. That would somehow untie some of her financial wealth from Telstar.