Stock Options and the Limitation with the Case

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Stock Options and the Limitation with the Case of e. Bay

Stock Options and the Limitation with the Case of e. Bay

Q 1. the agency theorists’ rationale for using stock options to align the interests

Q 1. the agency theorists’ rationale for using stock options to align the interests of shareholders and managers?

Multiple Purposes of Stock Option • By introducing management incentives - Raise management efficiency

Multiple Purposes of Stock Option • By introducing management incentives - Raise management efficiency resulting in shareholders’ profits - Lower agency costs and increase in management transparency by making people in the company the shareholders • - Securing human resources Ventures : inducing high calibres Large caps : retaining key management Financial institutions : aligning the interests between managers and shareholders • Increase employees’ welfare for • Enjoying tax incentives - Tax benefits to the firms, especially venture firms - Lower income tax to the receivers

Situational Outputs Market Performance • Stock option did not contribute to the management achievement

Situational Outputs Market Performance • Stock option did not contribute to the management achievement and market performances - Lower performance than the average in the floors - No correlation between stock growth rates in the market and stock option Company Practice • Exploited the tax system for a few special insiders - A way of risk-free bonus, no downward payments - some times corruption like Back Dating Giving potential shareholders’ status is a matter of future (uncertain) and no contribution to the company value • Lu Gusner in IBM bought IBM stocks in the market !!

Wide-spread practice with limitation • For the current shareholders, it is the costs in

Wide-spread practice with limitation • For the current shareholders, it is the costs in P&L accounting, which result in lower dividends given to agents who did not invest (Microsoft) • It is against the fair treatment of current shareholders due to lower strike price • It is against minority interests in keeping exclusive rights to the management team and special relates in running the company • The chance of conflicts between the receivers and non-receivers making lower morals or incentives to work (Netscape) - This situation may force able people to leave the company

e. Bay should keep going ! • Major Sources of Problems - Industry Generic

e. Bay should keep going ! • Major Sources of Problems - Industry Generic + Business Achievement + Organizational Stage • Lack of internal resources, • market situation - Industry cycle and venture economy • Rapid technology life cycle and steep experience curve • Opportunistic humans behaviors

Q 2. Should e. Bay expense the stock option and report a loss?

Q 2. Should e. Bay expense the stock option and report a loss?

Issues regarding the expensing of stock options • There are two main issues surrounding

Issues regarding the expensing of stock options • There are two main issues surrounding the recording of an expense when an option is awarded - Does the expensing provide a level playing field in accounting for management compensation? - Would the recording of an expense when an option is awarded improve corporate governance?

Stock Option Expensing will provide a level playing field so that companies that use

Stock Option Expensing will provide a level playing field so that companies that use cash bonuses and companies that use stock options each have an expense on the income statement Pros • Matching accounting principles having costs-benefits in the time • Making the EV appropriate and the economic system stable • Allowing control information on corruption by management • Corporate governance will be improved by reducing or eliminating incentives to inflate income and earnings per share Cons • Already known information in the footnotes of financial reports • Making rapid decrease in business performance winding up many side effects • Uncertainty in the calculations of option costs (limitation of model)

Who are they? Approvers High Bowers Institutions Researchers /Interest groups ►A Disapprovers President Bush,

Who are they? Approvers High Bowers Institutions Researchers /Interest groups ►A Disapprovers President Bush, Senator Joe Warren E. Buffett, Alan Greenspan, Senator Carl Levin, Lieberman John Mc. Cain Arthur levitt (former SEC chairman), IASB 80 percent of U. S. financial analysts, Association for Investment Management and Research, Council for Institutional Investors Harvey Pitt (SEC Chairman) Association for Financial professionals, Financial Executives International, National Venture Capital Association, U. S. Chamber of Commerce power game to keep their interests using narratives

Better Direction • According to accounting principals, Accrual-Based Accounting (GAAP) and for the better

Better Direction • According to accounting principals, Accrual-Based Accounting (GAAP) and for the better market system, it is better to have stock Option expensing in the beginning of development • The goal of a company is to maximize its value - The shareholders want to have reliability about the financials and the accounting numbers • Achieving better performance through adjusted stock option plans using - Industry index, evaluation by the compensation committee, devil’s advocate to control risks (Enron case), etc.

Q 3. Why Black-Scholes fails to solve the agency problem?

Q 3. Why Black-Scholes fails to solve the agency problem?

No Consideration Managemental Practice Risk Taking Attitude • The management will be inclined to

No Consideration Managemental Practice Risk Taking Attitude • The management will be inclined to grow the company rapidly hence making the company more risky especially when options are out-ofmoney) – If the risky strategy does not live up to expectations (the more debt more risky, a lower value) Externalty • Inordinate compensation in the bull market by external factors, meaning free riders Other problems with Black-Scholes • Potentially overstates the value of employee stock options • The model also assumes that the options can be traded in the market

Issues and assumptions regarding the option pricing models • Frictionless markets - No transaction

Issues and assumptions regarding the option pricing models • Frictionless markets - No transaction costs, no tax and perfect liquidity - No dividends, fixed date (European Option) • Continuous trading - Trades can be performed at any time and in any amount. Even discrete models frequently assume a continuous limit • Unlimited short selling and borrowing are possible and the proceeds are immediately available • There are no arbitrage opportunities • Both the buyer and the seller of the underlying property are driven only by profitability of the trade

Relationship between corporate governance, IOS and control variables Corporate Governance Control variables Performance Size

Relationship between corporate governance, IOS and control variables Corporate Governance Control variables Performance Size Ownership Risk Option Valuation Investment Opportunity Set

A better direction Stock Prices Exercise Prices Issuing Date Exercising date Floating Exercise Prices

A better direction Stock Prices Exercise Prices Issuing Date Exercising date Floating Exercise Prices by stock incex, industry index, competitiors’ performance, etc. Time Number of Stocks Numbers of Stocks based on long term performance like ROI, EVA, etc. Issuing Date Exercising date Time