DERIVATIVES IV / PHILIP BROWN AND IAN DUNLOP

VALUING EMPLOYEE SHARE OPTIONS: FOUR AUSTRALIAN

CASE STUDIES

his is the fourth and final paper in this series on accounting for derivatives. T We take four case studies to illustrate

three issues: how ESOs are valued; how the valuation depends on assumptions about key variables; and how the US proposals to account for ESOs would affect the employer’s financial profile.’

T h e four companies whose ESOs we study are Brambles Industries, Coles Myer, Tabcorp Holdings and Westpac Banking Corporation. T h e Brambles ESO plan has been operating for some years and is well known. T h e other three are high-profile cases where sizable tranches of options have been offered to secure the services of chief executives. In Tabcorp’s case we have the added complication of valuing long-lived options for an initial public offering (IPO).

We follow the FASB proposal to value the options based on a recognised option valuation model. We adopt the Black-Scholes model because it is probably more familiar to the business community (we made the calculations using Mathcad 5+ on a PC). T h e task is to value an ESO at the grant date, given six factors: the share price on the grant date, the number of years from the grant date to the expected exercise date, the share’s estimated volatility over the option’s life, the option’s exercise or strike price, the risk-free interest rate, and projected dividends from grant to exercise.

We take four case studies to illustrate three issues: how ESOs are valued; how the valuation depends on assumptions; and how US proposals to account for ESOs would affect a company5financial profile. We adopt the Black-Scholes options model to value ESOs issued by Brambles Industries, Coles Myer, Tabcorp Holdings and Westpac Banking Corporation. Under the FASB’s proposal, after-tax profit is lower and shareholders’ funds and assets are higher beginning with the grant date. At the end of the amortisation period, assets and shareholders’ funds would be the same as under current practice, but the fair value of the ESOs on their grant date would have been transferred from unappropriated profits to issued capital.

A U S T R A L I A N A C C O U N T I N G R E V I E W V O L . 4 N 0 . 2 1 9 9 4 3 5

For each ESO we establish reasonable values for the six factors and compute a base case valuation. We then investigate the sensitivity of that valuation to a *l% change in the dividend yield, a 4% change in volatility, a *l% change in the risk-free rate, and to exercise two years early.’ T h e remaining two factors, the share price on the grant date and the strike price, are fured by the issue terms.

Australian companies do not disclose ESOs in a uniform way, so we used several publicly available data sources. Correspondence in stock exchange files, newspaper articles, annual reports, and in Tabcorp’s case the IPO prospectus, were consulted for the terms of each issue (that is, the number of options, grant date, vesting date, exercise price, expiry date and special conditions that applied). With the exception of Tabcorp, volatility is estimated over the five years to the grant date. The risk- free rate is assumed to be the yield on Commonwealth government bonds maturing around the option’s expiry date; the base dividend rate is the dividend yield on the grant date; and the share price on the grant date is the last sale price recorded in the Australian Financial Rmim. Since the Black-Scholes procedure is a continuous time model, all volatility and yield calculations are done on continuously compounded rates of return.

.

THE OPTIONS AND THEIR VALUATIONS

Brambles Brambles’ option plan applies to directors and

employees. T h e options are issued free and are approximately at the money (ie, exercise price equals market price) on the grant date. T h e options have a five-year life and vest in tranches of 20% at the end of years 2,3 and 4, and 40% three months before expiry at the end of year 5. The plan was amended in November 1993 to give the board discretion to impose minimum performance requirements in the nature of growth hurdles for share prices, dividends, EPS and total shareholder return. These requirements complicate the valuation process. They lower the value of the options because they reduce the probability the options can be exercised. The amendments do not apply to the series we study.

The series we use is the issue of 3,764,598 options granted on 27 May 1993 when Brambles’ share price was $13.08.’ T h e exercise price is $12.84, the first tranche vests on 27 May

1995 and they all expire on 27 May 1998. At the grant date five-year bonds yielded 6.66% and Brambles’ dividend yield was 4.49% (both yields are continuously compounded). These data, and the results from our valuation, are shown in Table 1, with the sensitivity of the valuation to changes of *l% in the dividend yield, 4% in volatility, *l% in the risk-free rate, and to exercise two years early (ie, on 27 May 1996, although that was not possible for 60% of the options). Table 2 shows Brambles 1994 balance date, reported profit after tax and extraordinary items, the number of issued fully paid ordinary shares, shareholders’ funds, total assets, the options’ base case amount that under the US proposal would be recognised on the grant date as options outstanding (additional shareholders’ funds) and prepaid compensation (a deferred asset), amortisation expense for the fiscal year to 30 June 1994, and the 30 June 1994 balance sheet figures for accumulated amortisation and unamortised prepaid compensation.

of $2.27 per unit, assuming all were expected to be exercised on the expiry date. This translates into an aggregate value of $8.546 million for the 3,764,398 options that were granted. Straight- line amortisation of this value from grant to vesting date would have increased Brambles’, 1994 loss by $2.569 million, but shareholders’ funds and total assets would have been $5.737 million higher (capitalised amount less 1993 and 1994 amortisation). Our calculations ignore any deferred income tax complications.

T h e sensitivity analysis in Table 1 shows that a 1% variation in the dividend yield or a 5% variation in volatility, or alternatively an expectation that the options would be exercised two years early, would change the dollar amounts in the previous paragraph by 15% to 20%; a 1% variation in the risk-free rate would change them by about 10%. Because these percentage changes are only roughly additive, we also show in Table 1 that the combined effect of a 1% increase in the dividend yield, a 5% decrease in volatility, a 1 % decrease in the risk-free rate and exercise two years early (designated the “minimum value”) would be to halve the amounts. On the other hand, they would be half as much again if we were simultaneously to decrease the dividend yield by 1%, increase volatility by 5% and increase the risk-free rate by 1% (designated the “maximum value”; the base case exercise date is already at the m a ~ i m u m ) . ~

In sum, the option series had a base case value

3 6 A U S T R A L I A N A C C O U N T I N G R E V I E W

DATA No. of options Grant date Stock price Vesting date Expiry date Hurdle price Strike price Bond yield Volatility Dividend yield

VALUATION: Intrinsic value Base case value Dividend +1% Dividend -1% Volatility +5% Volatility -5% Risk-free rate +1% Risk-free rate -1% Exercise 2 years early Maximum value' Minimum value3

Brambles Tranches 1-4

3,764,598 27 May 93

$13.08 27 May 95' 27 May 98

NIA $12.84

6.66% 18.01% 4.49%

$0.24 $2.27

($0.35) $0.39 $0.41

($0.40) $0.25

($0.25) ($0.40) $3.30 $1.12

Coles Myer Tranche 1 Tranche 2

2,212,500 23 Dec 93

$5.39 1 Jul95

24 Nov 98 $6.19 $5.39 5.94%

19.81% 3.56%

0 $0.97

$0.16 $0.19

($0.19) $0.1 1

($0.10) ($0.23) $1.43 $0.43

($0.14)

2,212,500 23 Dec 93

$5.39 1 Jul95

24 Nov 98 $7 $5.39 5.94%

19.81% 3.56%

0 $0.88

($0.14) $0.16 $0.20

($0.22) $0.1 1

($0.10) ($0.26) $1.36 $0.30

Tabcorp

3,000,000 15 Aug 94

15 Nov 04 NIA NIA NIA

9.07% 20.42% 6.25%

$2.25

0 $1.19

$0.13 ($0.11)

NIA NIA NIA NIA

($0.15) $1.32 $0.91

Tranche 1

1,666,667 24 Jan 93 $2.90

25 Jan 96 25 Jan 98

NIA $2.85 7.95%

26.77% 6.02%

$0.05 $0.60

($0.07) $0.08 $0.08

($0.08) $0.04

($0.08) $0.81 $0.37

($0.04)

Westpac Tranche 2

1,666,667 24 Jan 93

$2.90 19 Jan 97 19 Jan 99 $3.90 $2.85 8.18%

26.77% 6.02%

$0.05

($0.08) $0.58

$0.09 $0.09

($0.10) $0.05

($0.04) ($0.08) $0.81 $0.31

Tranche 3

1,666,667 24 Jan 93

$2.90 19 Jan 98 19 Jan 00

$4.41 $2.85 8.27%

26.77% 6.02%

$0.05 $0.56

($0.09) $0.10 $0.10

($0.10) $0.05

($0.05) ($0.07) $0.82 $0.29

NOTES: 1. 2. 3.

Brambles' options vest 20% on 27 May 1995,27 May 1996 and 27 May 1997; the remaining 40% vest on 27 February 1998. The maximum valuation is the combined effect of a 1% lower dividend yield, 5% higher volatility and a 1% higher risk-free rate; the exercise date is unchanged. T h e minimum valuation is the combined effect of a 1% higher dividend yield, 5% lower volatility, 1% lower risk-free rate and exercise two years early.

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Co Zes Myer We study an ESO issue under T h e Coles

Myer Executive Share Option Plan. T h e ESO plan was designed to motivate and retain senior management. Shareholders were believed to benefit through higher productivity, strengthening the connection between executive performance and Coles Myer’s profitability, and ensuring that executives would not benefit under the plan unless shareholders also benefited.

at-the-money options were issued in two tranches of 2,212,500 at an issue price of one cent each. Of the 4.425 million, 2 million were issued to the managing director, Peter Bartels, and 300,000 each to John Barner (finance and administration director) and Peter Morgan (chief operating ~f f icer ) .~ Coles Myer’s share price was $5.39 on the grant date. Both tranches vest on 1 July 1995 and expire on 24 November 1998. T h e tranches differ with respect to their hurdle price: the first tranche imposes a hurdle price of $6.19 which the Coles Myer price must exceed before the options can be exercised, whereas the second tranche imposes a $7 hurdle price.6 Other relevant data are given in Table 1.

had a base case value of $0.97 and $0.88 per unit respectively, assuming 100% exercise on the expiry date (Table l), for an aggregate value of $4.093 million (Table 2). Amortisation would have reduced Coles Myer’s 31 July 1994 bottom line by $1.623 million (0.4%) while shareholders’ funds and total assets would have been $2.470 million higher (a negligible percentage change). T h e sensitivity analysis (Table 1) shows that a 1% change in the dividend yield or a 5% change in volatility would change these amounts by 15% to 25%, a 1% change in the risk-free rate would change them by a little more than lo%, while an exercise date two years earlier would reduce them by up to 30%. T h e combined effect of a 1% higher dividend yield, 5% lower volatility, 1% lower risk-free rate and exercise two years early would be to cut them by 55% to 60%.

On 23 December 1993, a total of 4,425,000

To summarise, the first and second tranches

Tabcorp Tabcorp Holdings’ IPO prospectus, dated 30

June 1994, provided information on an employee share loan plan. It was designed, according to the prospectus, to provide employees “with an additional incentive to improve Tabcorp’s profitability, and hence

shareholder returns”. Under the plan, each full-time employee was entitled to subscribe for 1,000 Tabcorp shares offered by the prospectus, where the subscription amount was financed by an interest-free loan. T h e loan is to be repaid by retaining a portion of cash dividends (the balance would be paid to the employee to meet any tax liability after taking account of franking credits) and from any surplus from capital transactions such as the sale of rights when the employee did not elect to take up a renounceable rights issue. T h e employee may, but need not, settle the loan before it is due for repayment. Shares acquired under the scheme are similar to ESOs: the employee can avoid share losses because the loan need not be repaid.

T h e prospectus also disclosed that Ross Wilson, newly-appointed managing director, had been recruited with a package that included his right to acquire 500,000 shares on the same terms and conditions as the employee share loan plan, plus an entitlement to subscribe for 3 million (1 %) of the shares offered by the prospectus. T h e 3 million shares were to be paid to one cent by Wilson from his own resources, while the balance was to be financed by an interest-free loan on terms roughly similar to loans advanced under the employee share loan plan.

Tabcorp’s IPO was marked by controversy, one issue being the seemingly generous quasi- options granted to Wilson.’ We focus on Wilson’s package, but recognise that other employees also subscribed, collectively, for a sizable number of shares on similarly favourable terms. We exclude the 500,000 shares from our valuation and focus on Wilson’s special allocation of 3 million shares.

T h e prospectus contained a forecast of an after-tax profit of $63.4 million, EPS of 21.1 cents and a fully franked dividend of 14.5 cents a share for 1994/95. For the base case, we assume the loan is expected to be repaid out of dividends etc. over 10 years. In this case, the exercise price is zero, and the value of the quasi-options is just the present worth of the shares in 10 years’ time. We estimate that present worth to be $1.19 per share, after subtracting the one-cent purchase price. When we consider exercise two years earlier, then the option element of the share issue applies. T h e strike price is the amount still owing (ie, the amount unrecouped from dividends paid or the sale of rights to new issues, over the eight years from the IPO date). We estimate the strike

3 8 A U S T R A L I A N A C C O U N T I N G R E V I E W

Brambles Coles Myer Tabcorp Westpac

Fiscal Year End Net Profit ($m) Issued FP Ord Shares (m) Shareholders’ Funds($m) Total Assets ($m) Option Value ($m) Amortisation ($m) Accum Amortisation ($m) Unam Prepaid Comp’n ($m)

30 Jun 94 (233)’ 217.9

1,406.4 2,841.4

8.546 2.569 2.808 5.737

31 Jul94 424.2

1,290.7 3,374.5 6,910.1

4.093 1.623 1.623 2.470

30 June 95 63.4‘

300.0‘ 810.0: 879.Z2

3.570 0.304 0.304 3.266

30 Sep 94 705

1,82 1 7,294

93,861 2.900 0.762 1.283 1.617

NOTES: 1. After abnormal expenses of $21.7m for discontinued operations and $356.5m write-off of goodwill. 2. Prospectus forecasts.

price would be 63 cents so that the quasi- options would be worth $1.04 each, assuming a constant dividend yield of 6.25% and volatility of 20.42% (an estimate based on daily returns over a limited trading history but not out of line with our volatility estimates for the other three companies). T h e pro-forma post- prospectus balance sheet showed shareholders’ funds of $810 million and total assets of $879 million. We use these figures in Table 2.

To summarise our findings, the 3 million quasi-options issued to Tabcorp’s managing director had a base case value of $1.19 per unit (Table 1) and an aggregate value of $3.57 million (Table 2):Under the FASB’s proposal, amortisation would have reduced Tabcorp’s 1995 forecast bottom line by $0.304 million (0.5 %), but the post-prospectus shareholders’ funds and total assets would have been $3.266 million (about 0.4%) higher.

Westpac On 24 January 1993 Westpac Banking

Corporation appointed a new managing director, Robert Joss, on a remuneration package that included 5,000,001 ESOs in consideration of his future services. Westpac’s closing share price had averaged $2.85 over the week before the appointment; that average was the exercise price for the options.’ On 20 May 1993 the agreement between the board and the CEO was formalised. T h e deed of agreement locked in three separate tranches of ESOs and was subject to shareholder approval. When the deed was signed on 20 May, Westpac’s price had risen to $3.61 and its

continuously compounded dividend yield was 4.87%. By the time shareholders approved of the agreement at a special meeting held on 15 July, Westpac’s price had risen another 37 cents to $3.98 and its dividend yield was 2.98%.

According to paragraph 82 of the FASB’s exposure draft, for accounting purposes the grant date is “the date at which an employer and an employee agree to the terms” of the issue, and in particular to the issue price. We use 24 January 1993 as the grant date but acknowledge that it is open to a different interpretation. Had we used the date of the deed of agreement, the options would have been worth another 42 cents per share; by the shareholders’ approval date they were worth a further 50 cents. Their higher intrinsic value and lower dividend yield account for the increases in value, and illustrate what is well known: options can be a highly leveraged form of investment.

In the first tranche Joss was issued with 1,666,667 free options exercisable at $2.85. On 24 January 1993 the options had an intrinsic value (share price less exercise price) of five cents each. These options vest on 25 January 1996 and expire two years later. T h e second tranche was formally issued on 19 January 1994 and the third is scheduled to be issued about the same time in 1995. T h e second issue vests three years after its issue date, is exercisable within the following two years, and has an exercise price of $2.85 and a hurdle price of $3.90. We assume the third tranche will be issued as scheduled; it will then vest three years later, and will also be exercisable within

A U S T R A L I A N A C C O U N T I N G R E V I E W 3 9

two years after the vesting date at a price of $2.85. Its hurdle price is $4.41. Other relevant data for the first, second and third tranches, all of which would affect Westpac’s 1994 results under the FASB proposal, are set out in Table 1.

We estimate that, in the base case, the first, second and third tranches of options had a value of 60 cents, 58 cents and 56 cents per unit respectively on the grant date, assuming 100% exercise on their expiry date; their aggregate value was $2.9 million (Table 2). Had Westpac applied the FASB’s proposed accounting treatment, Table 2 shows that amortisation of prepaid compensation would have reduced its 30 September 1994 bottom line by $0.762 million, while shareholders’ funds and total assets would have been $1.61 7 million higher. By the time the third tranche vests in January 1998, Westpac’s issued capital would be $2.9 million higher, its unappropriated profits $2.9 million lower, and other balance-sheet items would be unchanged.

SUMMARY

T h e trend towards tying executive compensation to shareholders’ benefits may well see increasing use of ESOs and put corporate Australia and accounting regulators on a collision course.

This paper illustrates how ESOs can be valued, and how accounting proposals in the US to recognise those values would, if they were adopted in Australia, affect the bottom line and key balance-sheet indicators. T h e data and methods we use are readily accessible to accountants and analysts who understand the principles of option valuation.

We chose the four cases for their general interest. They differ in their terms and conditions, but none poses any serious

Sensitivity analysis allows us to investigate how that worth changes as we change the

difficulty in estimating its basic worth. 1

assumptions of the valuation model. 2 In sum, after-tax profit is lower and

shareholders’ funds and assets would be higher

beginning with the grant date. At the end of the amortisation period, assets and shareholders’ funds would be the same as under current practice, but the composition of shareholders’ funds would be different. Absent tax effects, and all else equal, the FASB’s proposal would have the same effect as a transfer from unappropriated profits to issued capital (or to reserves in the case of

unexercised options), the amount transferred being the fair value of the ESOs on their grant date.

It would be misleading to generalise the magnitude of the income-statement and balance- sheet effects from these four cases alone; for a start, three of the four are among Australia’s largest companies, and the FASB’s proposals would have little effect on them. T h e impact on the financial performance and profile of any one company’s ESO plan would depend on its terms and conditions, the number of options relative to the company’s issued share capital, its share price volatility and dividend characteristics, and its profitability and financial position at the time. We can imagine that, in some cases, the impact would be substantial.’

Philip Brown is KPMG Peat Marwick Professor of Accounting and Ian Dunlop lecturer in finance at The University of Western Australia. The views expressed here are those of the authors and do not necessarily represent the views of KPMG Peat Marwick. We are indebted to David Low of Hartley Poynton for supplying the share price data we use. We are also indebted to Rob Brown, Bryan Howieson, Steve Tayloc our colleagues at The University of Western Australia,

and especially to Greg Clinch.

NOTES

The US proposals are discussed in the accompanying paper by Brown and Howieson. Because of their shorter lives, exchange traded option values typically are relatively insensitive to the risk-free rate. However,

4 0 A U S T R A L I A N A C C O U N T I N G R E V I E W

we are dealing with relatively long-lived options and discount rates can matter.

outstanding on the grant date (as reported by Brambles to the Australian Stock Exchange on 24 June 1993).

4 T h e fact that our maximum valuation is almost three times our minimum does not necessarily mean that the option value cannot be measured reliably from an accounting viewpoint.

5 Australian Financial Rtwim, 22 November 1993, p. 22.

6 A hurdle price can be accommodated by making a minor adjustment to the standard Black-Scholes formula. We assume for simplicity that the hurdle need be met on one day only. T h e actual agreement requires it to be met for five days in succession, which is a slightly more stringent requirement.

7 T h e Treasurer of Victoria, Alan Stockdale, was reported to have described his “failure to rigorously analyse” Wilson’s salary package as “his biggest mistake” (Australian Financial Rmim, 9 September 1994, p. 6). T h e same story reported that “Wilson’s three-year salary has been

3 There were 4,316,843 other ESOs

estimated at $8 million”. In a later story, Wilson was reported to have “admitted that his annual salary could top $1.5 million”. It was reported that his package “includes a $680,000 base salary, a relocation loan to shift from Adelaide to Melbourne, and an interest-free loan to buy Tabcorp shares” (Australian Financial Rtwim, 27 September 1994, p. 55).

8 Australian Financial Rtwim, 4 October 1994, p. 55.

9 Some US estimates are given in the accompanying article by Brown and Howieson.

Mail or fax to: Melissa Edward, Australian Society of CPAs, GPO Box 2820 AA, Melbourne Vic 3001. Fax No. (03) 670 8901

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