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Derivative Securities Larry Steffen: Valuing Stock Options in a Compensation Package It was 4:00 p

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Derivative Securities Larry Steffen: Valuing Stock Options in a

Compensation Package

It was 4:00 p.m. on May 29, 2013, and this was proving to be an exciting and anxious day for Larry

Steffen. Harvard Business School’s Diploma Ceremony would be held tomorrow afternoon, and he was busy coordinating transportation and a convenient meeting place on Baker Lawn for his family and friends. Before he could relax and fully enjoy tomorrow’s commencement activities, however,

Steffen has a very important decision to make: he must choose one of the two alternative compensation packages offered to him by Athena Global Technology (“Athena”), and notify the

company of his selection by 6:00 p.m. today.

Athena, a publicly traded global technology and communications company, was trying to fill an open position in their information technology operations group, and Susan Klein, the hiring manager, believed that Steffen’s experience, skills, and tools were an excellent match for the position.

He had been attracted to Athena since his first contact and on-campus interview with the company, and considered the position to be an ideal first job straight out of graduate school. Steffen was delighted when he received the written offer from Susan Klein, and he had decided to accept the job offer; but he now had to select one of two alternative compensation packages being offered: a base salary plus a cash bonus, or the same base salary plus employee stock options.

Steffen had spoken with Susan Klein earlier that day, and most of the discussion related to the

compensation packages. A partial transcript of the conversation follows:

Susan Klein: “We think you’ll be a strong contributor to Athena and our I.T. operations group, and

we’re very pleased that you have decided to come to work with us. We can offer you a starting

salary of $120,000 per year, and in addition you will receive a one-time signing bonus.”

Larry Steffen: “The base salary is a bit less than the amount I had anticipated. Is this number

negotiable?”

Klein: “This base salary amount is not negotiable; it’s the same salary that all our new MBAs are

getting. We recognize that this amount may be on the low side, so we’re also offering a bonus

payment. This bonus is $20,000 in cash, or you can choose stock options instead of the cash.”

9-914-517

 DECEMBER 2, 2013

For the exclusive use of L. Ferraro, 2022.

This document is authorized for use only by Logan Ferraro in FIN 4615 & 5615 Derivatives Securities (Fall 2022) taught by Wei Huang, University of Minnesota - Duluth from Aug 2022 to Dec

2022.

914-517 | Larry Steffen: Valuing Stock Options in a Compensation Package

2 BRIEFCASES | HARVARD BUSINESS SCHOOL

Steffen: “Okay, this makes the compensation package much more attractive. The cash bonus is simple

enough, so could you tell me more about the stock options?”

Klein: “No problem. Our board of directors believes that employee stock options are an important

part of Athena’s overall compensation package. Stock options help align the interests of our

managers and employees with our shareholders, as actions that increase stock price and

shareholder value benefit both groups. It is true that some companies are moving away from

stock options toward other forms of performance-based compensation, and that Athena’s

common stock performance has been fairly volatile during the past ten years, but the board

remains convinced that stock options are the best form of incentive compensation for the

company and its managers and employees.

“The stock options we’re offering will give you the right, but not the obligation, to purchase

Athena common stock, at a known price, after a set period of time. Stock options provide

managers and employees with a powerful incentive to take actions that increase the stock price,

as they will personally benefit when the stock price rises.”

Steffen: “This all sounds very interesting. Can you tell me how much these stock options are worth?”

Klein: “Well, I’m not quite sure, but I do know the details of your stock options offer. You will be

granted the option to buy 5,000 shares of our common stock, and the purchase or exercise price

will be Athena’s market price at the close of today’s trading. The options will not be vested until

you have been with Athena for five years; you could exercise your stock options and purchase

the 5,000 shares any time after your fifth anniversary with the company, but they must be

exercised before your tenth anniversary. And if you leave the company before the five-year

vesting period, you will lose your options. You cannot exercise the options early, nor can you

transfer them to someone else or take them with you. In addition, our common stock does not

currently pay a dividend, and it is not expected to pay a dividend during the foreseeable future.

“I’ve also been told that you would not pay income tax on the options until you actually exercise

them and sell the shares. At that time you would recognize a taxable gain equal to the sale price

minus the exercise price. If you have held the shares for less than one year when you sell them,

any gain will be taxed as ordinary income, but if you’ve held the shares for more than one year

the gain will be taxed as a long-term capital gain. If you instead take the $20,000 cash bonus, this

entire amount will be taxed as ordinary income.1

“The choice between the cash bonus and the stock options is yours. Most of our new MBA hires

have selected the cash bonus, but a few have instead selected the stock options. Whatever your

choice, I need to know your decision by 6:00 p.m. today. Please send me an e-mail stating your

acceptance of our job offer and also stating your selection of the cash bonus or stock options.”

It was interesting that most new hires preferred the cash bonus, but Steffen wondered if the stock

options were actually the superior alternative. Opening up his computer and accessing a financial

website, he found that both short-term and long-term call options on Athena’s common stock were

traded in the financial markets. A sample of today’s closing market quotes on Athena’s call options is

presented in Exhibit 1. From the same web site he also found a graph presenting Athena’s common

stock price over the last ten years, as well as a graph of the historical volatility of Athena’s stock price

over the same period, with volatility measured by the annualized standard deviation of daily stock

returns. These graphs are shown in Exhibits 2 and 3, respectively. And, finally, Steffen found current

market yields on U.S. Treasury securities, as presented in Exhibit 4, which are helpful in determining

the value of the stock options being offered by Susan Klein and Athena.

 

1 In May 2013, Larry Steffen’s marginal tax rate for ordinary income was 28%, and his tax rate on long-term capital gains was

15%.

For the exclusive use of L. Ferraro, 2022.

This document is authorized for use only by Logan Ferraro in FIN 4615 & 5615 Derivatives Securities (Fall 2022) taught by Wei Huang, University of Minnesota - Duluth from Aug 2022 to Dec

2022.

Larry Steffen: Valuing Stock Options in a Compensation Package | 914-517

HARVARD BUSINESS SCHOOL | BRIEFCASES 3

After thinking about the stock options and the information he had collected, Steffen decided to

analyze the problem in two stages. The first stage required him to estimate the value of the stock

options, assuming he would remain with Athena for at least five years. The second stage would

consider other issues and concerns, including the possibility that he might not remain with Athena

that long.

 

For the exclusive use of L. Ferraro, 2022.

This document is authorized for use only by Logan Ferraro in FIN 4615 & 5615 Derivatives Securities (Fall 2022) taught by Wei Huang, University of Minnesota - Duluth from Aug 2022 to Dec

2022.

914-517 | Larry Steffen: Valuing Stock Options in a Compensation Package

4 BRIEFCASES | HARVARD BUSINESS SCHOOL

Exhibit 1 May 29, 2013 Closing Market Quotes for Call Options Written on Athena Common Stock

Call Options Expiring in 2013:

Exercise Expiration Date

Price 22-Jun-13 20-Jul-13 17-Aug-13 19-Oct-13

$20 $2.74 $2.85 $2.95 $3.23

$21 $1.83 $2.03 $2.18 $2.53

$22 $1.07 $1.36 $1.55 $1.91

$23 $0.52 $0.86 $1.07 $1.44

$24 $0.22 $0.51 $0.66 $1.04

$25 $0.09 $0.25 $0.42 $0.77

Long-Term Call Options:

Exercise Expiration Date

Price 18-Jan-14 17-Jan-15

$20 $3.63 $4.84

$21 $2.98 $4.33

$22 $2.47 $3.80

$23 $1.99 $3.45

$24 $1.62 $3.03

$25 $1.24 $2.63

Athena’s closing common stock price on May 29, 2013, was $22.71.

For the exclusive use of L. Ferraro, 2022.

This document is authorized for use only by Logan Ferraro in FIN 4615 & 5615 Derivatives Securities (Fall 2022) taught by Wei Huang, University of Minnesota - Duluth from Aug 2022 to Dec

2022.

914-517 -5-

Exhibit 2 Market Price of Athena Common Stock, June 2003 through May 2013

Athena’s closing common stock price on May 29, 2013, was $22.71.

$5

$0

$45

$40

$35

$30

$25

$20

$15

$10

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Common Stock Price

For the exclusive use of L. Ferraro, 2022.

This document is authorized for use only by Logan Ferraro in FIN 4615 & 5615 Derivatives Securities (Fall 2022) taught by Wei Huang, University of Minnesota - Duluth from Aug 2022 to Dec

2022.

914-517 -6-

Exhibit 3 Volatility of Athena Common Stock, June 2003 through May 2013

Volatility is measured by the annualized standard deviation of daily stock returns over the prior three months’ trading.

0%

80%

60%

40%

20%

120%

100%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Annualized Standard Deviation of Daily Stock Returns

For the exclusive use of L. Ferraro, 2022.

This document is authorized for use only by Logan Ferraro in FIN 4615 & 5615 Derivatives Securities (Fall 2022) taught by Wei Huang, University of Minnesota - Duluth from Aug 2022 to Dec

2022.

Larry Steffen: Valuing Stock Options in a Compensation Package | 914-517

HARVARD BUSINESS SCHOOL | BRIEFCASES 7

Exhibit 4 Market Yields on U.S. Treasury Securities as of May 29, 2013

 Maturity

Annualized

Yield

 1 month 0.04%

 3 months 0.05%

 6 months 0.08%

 1 year 0.14%

 2 years 0.30%

 3 years 0.49%

 5 years 1.02%

 7 years 1.51%

 10 years 2.13%

 20 years 2.91%

 30 years 3.27%