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Unformatted text preview: Mini Case: 6 - 1 Chapter 6 Financial Options ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 6-1 See the BOC model. Based on the Black-Scholes model, we see that the value of the option increases with the stock price, time to expiration, variance, and the risk-free rate. The option value declines with increases in the strike price. 6-2 As discussed in the chapter, options are compensation, compensation is an expense, and expenses should be deducted from revenues when calculating income. Therefore, options should be deducted on the income statement. However, if options are to be expensed, their values must be estimated. Although it may not provide an exactly precise estimate of the “true” value of an option, the Black-Scholes model can give us a reasonably good estimate of the option’s value, and that estimate can be used both to let employees know what they are getting when they are granted options and also for purposes of expensing options. Companies need to provide some specific level of compensation, and total compensation might consist of regular salary, a cash bonus for targeted performance levels, and stock options. The value of the options must be estimated if a rational compensation package is to be established. High tech companies have made the greatest use of options. The companies benefited from reduced cash requirements during their rapid growth phase, and many employees of successful companies became millionaires. However, options produced problems in the period 2000-2002, when stock prices fell sharply, driving down the values of options awarded in earlier years. The stock collapses were due primarily to a general decline in the market from its “bubble” high, not by poor employee performance. If an employee had received options whose value was based on an unrealistically high stock price, and if that price later declined sharply, then it could be argued that his or her “true” past compensation was too low. Should the company now re-price its outstanding options, lowering the strike price so as to make the options valuable and thus provide the expected level of total compensation? And, if options are re-priced, is this fair to stockholders, who don’t get any comparable treatment? This is an issue that many companies are currently struggling with today. It’s interesting to note that in 2003 Warren Buffett had Berkshire Hathaway expense options, and he hired two Wall Street firms to find a value of the options. It turned out that their values were consistent with Black-Scholes, indicating that even investment banking firms value options with Black-Scholes. It appears that Buffet will give up on trying to improve on Black-Scholes and will simply use it. We agree. We agree....
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- Spring '08
- Options, Strike price