a new graduate, you have taken a management position with Exotic Cuisines,
Inc., a restaurant chain that just went public last year. The company’s
restaurants specialize in exotic main dishes, using ingredients such as
alligator, buffalo, and ostrich. A concern you had going in was that the
restaurant business is very risky. However, after some due diligence, you
discovered a common misperception about the restaurant industry. It is widely
thought that 90 percent of new restaurants close within three years; however,
recent evidence suggests the failure rate is closer to 60 percent over three
years. So, it is a risky business, although not as risky as you originally
your interview process, one of the benefits mentioned was employee stock
signing your employment contract, you received options with a strike price of
$50 for 10,000 shares of company stock. As is fairly common, your stock options
have a three-year vesting period and a 10-year expiration, meaning that your
cannot exercise the options for a period of three years, and you lose them if
you leave before they vest. After the three-year vesting period, you can
exercise the options at any time. Thus, the employee stock options are European
(and subject to forfeit) for the first three years and American afterward. Of
course, you cannot sell the options nor can you enter into any sort of hedging
agreement. If you leave the company after the options vest, you must exercise
within 90 days of forfeit.
Cuisines stock is currently trading at $24.38 per share, a slight increase from
the initial offering price last year. There are no market-traded options on the
company’s stock. Because the company has been traded for only about a year, you
are reluctant to use the historical returns to estimate the standard deviation
of the stock’s return. However, you have estimated that the average annual
standard deviation for restaurant company stocks is about 55 percent. Because
Exotic Cuisines is a newer restaurant chain, you decide to use a 60 percent
standard deviation in your calculations. The company is relatively young, and
you expect that all earnings will be reinvested back into the company for the
near future. Therefore, you expect no dividends will be paid for at least the
next 10 years. A three-year Treasury note currently has a yield of 3.8 percent,
and a 10-year Treasury note ahs a yield of 4.4 percent.
are trying to value your options using BSM Model. What values would you assign,
using 3-year and 10-year as the time to maturity?
that, in three years, the company’s stock is trading at $60. At that time,
should you keep the options or exercise them immediately? What are some
important determinants in making such a decision?
options, like most employee stock options, are not transferable or tradable.
Dose this have a significant effect on the value of the options? Why?
do you suppose employee stock options usually have a vesting provision? Why
must they be exercised shortly after you depart the company even after they
controversial practice with employee stock options is repricing. What happens
is that a company experiences a stock price decrease, which leaves employee
stock options far out of the money or “underwater.” In such cases, many
companies have “repriced” or “restruck” the options, meaning that the company
leaves the original terms of the option intact, but lowers the strike price.
Proponents of repricing argue that because the option is very unlikely to end
in the money because of the stock price decline, the motivational force is
lost. Opponents argue that repricing is in essence a reward for failure. How do
you evaluate this argument? How does the possibility of repricing affect the
value of an employee stock option at the time it is granted?
we have seen much of the volatility in a company’s stock price is due to
systematic or marketwide risks. Such risks are beyond the control of a company
and its employees. What are the implications for employee stock options? In
light of your answer, can you recommend an improvement over traditional
employee stock options?