How is It Possible For an Employee Stock Option to Be Valuable Even If the Firm’s Stock Price Fails to Meet Shareholders Expectations?

Topics: Option, Stock, Derivative Pages: 3 (607 words) Published: August 1, 2012
(13-5) How is it possible for an employee stock option to be valuable even if the firm’s stock price fails to meet shareholder’s expectations?

Employees have the option of buying stocks because stock options are in essence the right to buy a specified number of shares at a specified price known as the “strike price”, within a specified period of time. There are several ways an employee stock option could be valuable. The option pays off if, at option expiration, the stock price is higher than the option’s strike price. If at any point the company fails to meet shareholders’ expectations, the stock price will probably drop. However, if the current price is high enough, the stock price is higher than the strike price. For instance, if the strike price is $50, the stock is currently at $100, and the stock drops to $80, the option is still worth $30. The value of the employee stock option is based on the difference between the current stock prices, while the shareholder expectations are based on what shareholders collectively think the stock should be worth. If a share of stock is worth more than the strike price, but less than what the shareholders expect, then it’s possible for an employee stock option to be more valuable.

(15-8) The Rivoli Company has no debt outstanding, and its financial position is given by the following data:

a. What effect would this use of leverage be on the value of the firm?

Original value of the firm: V= D + S
= 0 + ($15)(200,000)
= $3,000,000

Original cost of capital:WACC = wd(1-T)rd + wsrs
= 0 + (1.0)(10%) = 10%

With financial leverage (wd = 30%):WACC = wd(1-T)rd + wsrs
= (0.3)(7%)(1-0.40) + (0.70)(11%)
= 8.96%

Since the growth is zero, the value of the company is:

= [EBIT)(1-T)]/WACC
= [($500,000)(1-0.4)]/(0.0896)
= $3,348,214

Therefore, increasing the financial leverage by adding $900,000 of debt increases the firm;s value from $3,000,000 to...
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