ACC 333 (Farrell)
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In-Class Activity Reading
Stock Options—The Good, The Bad, and The Ugly?
Glossary of Terms – Read This Before You Read the Articles!
incentive stock option
When a firm gives an employee a stock option, that person has the right to:
purchase a share of firm stock
at a specified price (the “exercise” or “strike” price, which is the price that will be in effect when the purchase is made regardless of
what the market price of the stock is at that time)
at some point in the future (specified by the “vesting period”, and typically several years from the date the option was given to, or
“granted”, to the employee).
The employee is not obligated to purchase the shares after vesting, or ever. However, if the employee leaves the firm before vesting, he/she
forfeits the options.
Options are “repriced” when the Board of Directors changes the exercise price after the options have been issued to the
“in the money” and “out of the money”
Options are “in the money” when the exercise price is lower than the market price of the stock, and
are “out of the money” (also called “underwater”)
when the exercise price is higher than the market price of the stock.
Black-Scholes option pricing model
A model used to calculate the value of a particular type of option (“call options”) traded in the open
market. Some suggest that this model can also be used to calculate the value of employee stock options, but there are features of employee
stock options that are quite different from call options (e.g., the vesting period, employee stock options cannot be traded).
market prices and dividends
The market price for a share of stock is the price at which the stock is currently trading on the stock exchange,
and is theoretically computed as the present value of future cash flows that an owner of the stock expects to receive from the firm. In other
words, when you purchase a share of stock, you are purchasing a piece of ownership, and thus are entitled to a share of all future earnings
of the firm. The firm pays you your share of its earnings via periodic dividends, and if the firm terminates you’re entitled to a share of its
remaining net assets at that time, too. The market price at any point in time, then, is the present value of all dividends you expect to receive
from the firm from today until the firm terminates, plus any remaining net assets you’ll receive at termination. Note that if a firm pays a
dividend, market price will go down since the owners are receiving a portion of the expected cash flow on which the market price is based.
A firm can purchase shares of its own stock off the market, thereby reducing the number of shares outstanding (i.e., the
number of shares in the hands of owners). Amongst other reasons, this may be done so that the shares can be used for employee benefit
plans (e.g., 401K or retirement plans).
dilution / diluted earnings