Sally Jameson: Valuing Stock Options in a compensation Package (Abridged)

Soufiane M. Errahhaly

Fall 2010

AF-495: Case 3 - Sally Jameson

Prof. Chugl Lal

Soufiane.errahhal001@umb.edu

12/2/2010

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Sally Jameson: Valuing Stock Options in a compensation Package (Abridged)

Introduction:

Sally Jameson is a second year MBA student at Harvard Business School. She got an offer from the first interview with the Telstar Company. She had $50,000 as a starting salary and she has to choose one of the two options which are $5000 cash bonus or stock compensation instead. In this paper, I will talk about the advantages and disadvantages of both sides and make a decision.

Options:

To begin, if Sally would choose the first option which is take the cash bonus she can simply invest her $5,000 in 5 years T-bills (free risk) and if there is no tax, the future value of her compensation would be worth: $5000 x (1+0602) ^5 = $6754.49 in 5 years. (Future Value = Present Value * (1 + interest rate) ^time) (5-year T-bills’ interest rate is 6.02% in the Exhibit 4).

If Sally choose the stock option and assume that she will hold options until maturity. First, if Telstar’s stock price is below strike price which is $35 per share in our case, Jameson will not exercise her options and therefore will get nothing. Second, if Telstar’s stock price is above strike price, Jameson will exercise her options, sell shares and get profits = 3000 x (stock price – strike price). The higher stock price, the higher profit she will get. Furthermore, the stock price must be at least $37.2515 in order to get the same profit as the cash option. (6574.49/3000 + 35= $37.2515)

Before sally makes the final decision, she should think of other factors that may affect her outcome. First, if Sally quit before the maturity date, her options will worth nothing. As it stated on the case if she leaves the company she can’t take her stock options with her. Second, if we consider taxes sally will receive less cash money and end up by investing less money and getting less return when she invest in the T-bill.

Our professor Chugh asked us to estimate the price of option by going to ERI Black Scholes Model on the web. From the case, we have the strike price, current stock price, interest rate and maturity. We only have to use the appropriate volatility.

Option holders pay strike prices to corporations when they exercise options. In this case, Sally has to pay 35$ to the corporation when she exercises her options. This will lead the corporation to receive cash and issue new shares. In general, at expiration, corporations will have more cash and more outstanding shares. Granting stock options costs companies the value for which options are sold. Companies do not pay for such value directly. Instead, this value will be deducted in employees’ cash compensation. In other words, employees pay for options value by receiving less cash compensation by an amount equivalent to options value. 

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Sally Jameson: Valuing Stock Options in a compensation Package (Abridged)

Exhibit 1

Based on this web page I calculated the values of the option price in the following table.

Case 1 Case 2 Case 3Current Share Price ($) 18.75 18.75 18.75

Exercise Price ($) 35 35 35Expected Time to Expiry (Years) 5 5 5

Risk Free Interest Rate (%) 6.02 6.02 6.02Expected Dividend Yield on Share

(%) 0 0 0Expected Volatility of Share Price

(%) 35 50 47

This Option is Valued at $3.757 $6.232 $5.749

Value of 300 Shares $11,271. $18,696. $17,247.

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Sally Jameson: Valuing Stock Options in a compensation Package (Abridged)

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Case 1:

I used the average of the volatility of Telstar common stock (1982-1992) and I came up with 35%. Then I calculated the price of the option which is $3.757. As we know already Sally has 3000 options therefore she is getting 3000 * $3.757 = $11,271

Case 2:

I used the1992 volatility of Telstar common stock which is 50%. Then I calculated the price of the option which is $6.232. As we know already Sally has 3000 options therefore she is getting 3000 * $6.232 = $18,696

Case 3:

I used the average of five years volatility of Telstar common stock which is 47%. Then I calculated the price of the option which is $5.749. As we know already Sally has 3000 options therefore she is getting 3000 * $5.749 = $ 17,247

Recommendation for Sally Jameson:

I think Sally should go with the first option which is taking the cash. This way she does not have to stay with the same company for 5 years especially if she gets a better opportunity. In exhibit 2 the highest stock price was almost $35 in 1990 and it fell to $18.75 in the late of 1992. So there is a big chance that the stock price won’t be higher than $35. By taking cash she does not have to worry about the changing of the stock price. As we know already if the stock price stays below $35 she can’t exercise her options because she will get nothing and in order to get the same profit as the cash compensation the stock price has to be $37.2515.

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