Chapter 12: Options and Executive Pay Flashcards
Considering stock options, what is a “call option”?
a financial security that gives its owner the right to purchase one share of a company’s stock at a fixed strike price or exercise price before an expiration date
Considering stock options, what is a “put option”?
a financial security that gives its owner the right to sell one share of a company’s stock at a fixed exercise price before an expiration date
T or F. Employee stock options are call and put options.
false, always call options
Formula for intrinsic value (for a call option)
Stock Price - Expected Price
What is difference between Black-Scholes Value and Intrinsic Value?
Black-Scholes Value is more accurate and more complicated to calculate
Considering employee stock options, why is it different from options that are traded on exchanges?
vesting period (typically 3-5 years)
not tradable
forfeited if employees leave the firm
Considering employee stock options, why is the value of stock options to employees not equal to market traded options?
risk aversion
undiversified
non-tradable
will be forfeited if you leave the firm
Considering employee stock options, what are the accounting costs of issuing these options?
Before 1994, options were free
Present-day companies are required to expense the value of the stock options given to employees
Considering the employee stock options, what are the economic costs of issuing these options?
Firms incur a substantial opportunity cost from issuing employee stock options
Firms must pay a risk premium to risk-averse employees, stock options are the most “expensive” common form of pay from economics perspective
Why give employees stock options?
1) Financing (frees up cash)
2) Sorting: attract employees who are willing to take risk and optimistic about likelihood of firms success
3) Retention (vesting period; forfeited if leave the firm)
What is the factual evidence that would support CEOs being paid too much?
the average wage of the median worker has been flat, while CEO compensation has gone up exponentially
Where has this increased CEO compensation come from in the last 20 years?
largely comes from the increased use of stock options
What is the Principal Agent’s view of executive pay?
Concerned with solving the agency problem
Problem: when one party (the principal) delegates work to another (the agent)
Goal: how to use appropriate incentives to motivate the agent to act in the best interest of the principal, which in this case is to increase stock options which would align interest of CEOs and shareholders
Explain how modern corporations is an example of Principle-Agent view of executive pay?
Firms are owned by shareholders(principal)
Shareholders delegate tasks to CEO (agent)
CEO’s interest in the firm is not identical to shareholders (agency problem)
What is the main goal of shareholder?
maximize firm value
