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Valuing Employee Stock Options

ISBN: 978-0-471-70512-3
336 pages
October 2004
Valuing Employee Stock Options (0471705128) cover image

Description

A comprehensive guide to understanding the implications and applications of valuing employee stock options in light of the new FAS 123 requirements
Due to the new requirements of the Proposed Statement of Financial Accounting Standards (FAS 123) released by the Financial Accounting Standards Board (FASB)-namely the fact that employee services received in exchange for equity instruments be recognized in financial statements-companies are now scrambling to learn how to value and expense employee stock options (ESOs). Based on author Dr. Johnathan Mun's consulting and advisory work with the FASB consulting projects with several Fortune 500 firms, Valuing Employee Stock Options provides readers with a comprehensive look at this complex issue.
Filled with valuable information on binomial lattice and closed-form modeling techniques, Valuing Employee Stock Options can help financial professionals make informed decisions when attempting to ascertain the fair-market value of ESOs under the new requirements.
Johnathan Mun, PhD, MBA, MS, CFC, FRM (San Francisco, CA), is Vice President of Analytical Services at Decisioneering, Inc., the makers of Crystal Ball analytical software. He is also the author of Applied Risk Analysis (0-471-47885-7), Real Options Analysis (0-471-25696-X), and Real Options Analysis Course (0-471-43001-3), all of which are published by Wiley.
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Table of Contents

List of Figures and Tables xi

Preface xv

Acknowledgments xvii

About the Author xix

PART ONE Impacts of the New FAS 123 Methodology

CHAPTER 1 Implications of the New FAS 123 Requirements 3

A Brief Introduction 3

An Executive Summary of the FAS 123 Valuation Implications 5

Summary and Key Points 8

CHAPTER 2 The 2004 Proposed FAS 123 Requirements 11

FAS 123 Background 11

Summary and Key Points 17

CHAPTER 3 Impact on Valuation 19

A Brief Description of the Different Methodologies 19

Selection and Justification of the Preferred Method 19

Application of the Preferred Method 21

Technical Justification of Methodology Employed 22

Options with Vesting and Suboptimal Behavior 26

Options with Forfeiture Rates 28

Options Where Risk-Free Rate Changes over Time 29

Options Where Volatility Changes over Time 32

Options Where Dividend Yield Changes over Time 32

Options Where Blackout Periods Exist 35

Summary and Key Points 39

CHAPTER 4 Haircuts on Nonmarketability, Modified Black-Scholes with Expected Life, and Dilution 41

Nonmarketability Issues 41

Expected Life Analysis 45

Dilution 49

Summary and Key Points 49

CHAPTER 5 Applicability of Monte Carlo Simulation 51

Introduction to the Analysis 51

The Black-Scholes Model 52

Monte Carlo Path Simulation 52

Applying Monte Carlo Simulation to Obtain a Stock Options Value 53

Binomial Lattices 53

Analytical Comparison 54

Applying Monte Carlo Simulation for Statistical Confidence and Precision Control 54

Summary and Key Points 64

CHAPTER 6 Expense Attribution Schedule 65

ESO Expense Attribution Schedule as Minigrants 65

Summary and Key Points 73

PART TWO Technical Background of the Binomial Lattice and Black-Scholes Models

CHAPTER 7 Brief Technical Background 77

Black-Scholes Model 77

Monte Carlo Simulation Model 79

Binomial Lattices 80

Summary and Key Points 81

CHAPTER 8 Binomial Lattices in Technical Detail 83

Options Valuation: Behind the Scenes 83

Binomial Lattices 87

The Look and Feel of Uncertainty 90

A Stock Option Provides Value in the Face of Uncertainty 92

Binomial Lattices as a Discrete Simulation of Uncertainty 94

Solving a Simple European Call Option Using Binomial Lattices 99

Granularity Leads to Precision 102

Solving American and European Options with Dividends 105

Customizing the Binomial Lattice 108

The Customized Binomial Lattice Model 109

Treatment of Forfeiture Rates 112

Summary and Key Points 115

Appendix 8A—Binomial, Trinomial, and Multinomial Lattices 115

CHAPTER 9 The Model Inputs 119

Stock and Strike Price 119

Time to Maturity 120

Risk-Free Rate 120

Dividend Yield 121

Volatility 121

Logarithmic Stock Price Returns Approach 121

Annualizing Volatility 123

GARCH Model 123

Market Proxy Approach 124

Implied Volatilities Approach 125

Vesting 125

Suboptimal Exercise Behavior Multiple 126

Forfeitures 127

Blackout Periods 128

Lattice Steps 128

Summary and Key Points 129

PART THREE A Sample Case Study Applying FAS 123

CHAPTER 10 A Sample Case Study 133

Stock Price and Strike Price 133

Maturity 135

Risk-Free Rates 136

Dividends 136

Volatility 136

Vesting 140

Suboptimal Exercise Behavior Multiple 141

Forfeiture Rate 145

Number of Steps 145

Results and Conclusions 147

Summary and Key Points 157

Appendix 10A—Introduction to the Software 158

Getting Started 158

ESO Toolkit 158

ESO Functions 161

Auditing Templates and Spreadsheets 164

PART FOUR Options Valuation Results Tables

APPENDIX Getting Started with the Options Valuation Results Tables 169

Thirty-Five Percent Volatility and 3-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 171

Seventy Percent Volatility and 3-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 179

Thirty-Five Percent Volatility and 5-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 187

Seventy Percent Volatility and 5-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 199

Thirty-Five Percent Volatility and 7-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 211

Seventy Percent Volatility and 7-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 227

Thirty-Five Percent Volatility and 10-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 243

Seventy Percent Volatility and 10-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 267

Glossary 291

Notes 295

About the CD-ROM 301

Index 305

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Author Information

JOHNATHAN MUN is Vice President of Analytical Services at Decisioneering, Inc., the makers of Crystal Ball® analytical software. His duties focus primarily on heading up the development of real options and financial analytics software powered by Crystal Ball. Prior to joining Decisioneering, he was a consulting manager and financial economist in the Valuation Services and Global Financial Services practice of KPMG Consulting, and a manager with the Economic Consulting Services practice at KPMG LLP. He holds a PhD in finance and economics, and an MBA and MS in management. Mun is also certified in financial risk management and in financial consulting. He is currently a visiting professor in finance, economics, and statistics at various universities, including the University of Applied Sciences (Germany), the Swiss School of Management (Switzerland), and Golden Gate University (California). Mun is the author of Applied Risk Analysis, Real Options Analysis, and Real Options Analysis Course, all published by Wiley. He continues to offer worldwide seminars and lectures on the topics of real options, simulation and risk analysis, and corporate finance.
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