# These six inputs yield an estimate of the options

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yout rate. These six inputs yield an estimate of the option's fair value. It is important we ecognize that management selects the model inputs and, thus, can exercise some discretion er the reported fair value. The option's value computed using Black-Scholes increases with estimated option life, risk-free interest rate, and stock price volatility; it decreases with estimated dividend payout. (Free online Black-Scholes option calculators abound, which plifies fair value estimation.) For analysis purposes, we can partly assess the quality of the rted fair values by comparing a company's model inputs to industry standards and to his- ical measures (of stock price volatility, for example). Some companies have recently switched from the common Black-Scholes model to a more plicated binomial (or lattice-binomial) valuation method (currently fewer than 1,000 of the -.000 publicly-traded U.S. companies use the binomial method). The basic mathematics of the lack-Scholes and binomial methods are identical, but the binomial method allows companies insert additional assumptions into Black-Scholes and some claim that this provides a more urate fair value. It also generally provides a lower fair value estimate than the Black-Scholes el, thus reducing the expense related to the options Returning to our Aon example, assume that the Black-Scholes fair value of the 100,000 tions granted is \$1,000,000. Thus, Aon records fair value compensation expense of \$250,000

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8-11 Module 8 I Equity Recognition and Owner Financing WE 250.000 OTA 87,500 TE 87,500 APIC 250,000 WE 250,000 I OTA 87,500 I TE I 87,500 APIC I 250.000 Cash 2,600,000 APIC 2,600,000 Cash 2,600,000 I APIC I 2,600,000 TP 350,000 OTA 350,000 TP 350,000 I OTA I 350,000 each year (fair value of \$1,000,000 spread over the four-year vesting period) and its additional paid-in capital increases by \$250,000 each year (or \$1,000,000 over the four years). Two poin are worth noting. First, Aon expenses the entire fair value of the options granted (\$1,000,0 regardless of whether the employee actually exercises the options. Second, subsequent chang in the options' value are not recognized in financial statements. Thus, the stock option expense and the increase to additional paid-in capital reflect the ESO fair value measured at the grant dare As with any expense, there are tax consequences to stock option expense. That is, net inco is affected on an after-tax basis-each dollar of expense is offset by a reduction in tax expense Granting stock options creates a book-tax timing difference because the expense is recognized - the income statement at the grant date but is deductible for income tax purposes at the exer . - date (see Module 5 for more details about book-tax timing differences). The general approa is that a deferred tax asset is recorded at the statutory rate for this timing difference. This diff - ence reverses when the options are exercised. (Most companies grant non qualified stock opti (NQSOs), which are taxed like other compensation but not until the options are exercised; NQSOs are exercised, the options' intrinsic value is taxed as ordinary income to the employee the employer takes a corresponding tax deduction for the intrinsic value.)
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