Are Stock Options a Good Idea?

Transcription

1 Are Stock Options a Good Idea? Case study 19.2 Prepared by Gustavo Hernandez ID#: JRSB120 Introduction to Business Group C for Tabea Berg, Instructor School of Business Northern Alberta Institute of Technology April 15, 2010

2 Table of Contents 1. Stocks are issued in the primary and secondary securities markets. Using the information in Chapter 19 regarding the securities markets, discuss how stock options operate in this market.error! Bookmark not def 2. Discuss the arguments for and against stock options. Why are they deemed to be a desirable form of executive compensation? Why are they sometimes considered just the opposite? Using the information on securities (stocks and bonds), design a compensation method to reward performance using securities in a way that does not encourage the excesses of the present system of stock options You are an executive of a major corporation. In the present economic times, would you be prepared to accept stock options as part of your compensation package? Give your reasons listing any implications that might arise from your position Works consulted... 5 i

3 1. Stocks are issued in the primary securities market and traded in the secondary securities markets. Using the information in Chapter 19 regarding the securities markets, discuss how stock options operate in these markets. Stocks are instruments that signify an ownership position (called equity) in a corporation, and represent a claim on its proportional share in the corporation's assets and profits. Most stock also provides voting rights. The companies issue stocks with the goal of to raise large amounts of capital quickly and without paying interests and principal, but also it could accomplish other goals (e.g.: issue stocks to compensate employees, pay to investors, and exchange for bonds). When a business offers shares to the public for the first time, it's called an initial public offering (IPO). The money that the company raises from an IPO comes from a group of banks that underwrites the offering. Once a market capitalization is determined, the banks offer the shares. The two most important stocks are Common and Preferred stocks (Griffin, Ebert, & Starke, 2008); both are characterized for three different properties: par value (the value set for PCC to the stock), market value (the price of the stock in the exchange market) and book value (the value of the stock for the PCC financial statement). The shares in the market are traded in the stock exchanges through brokers. Brokers receive order of buying and selling stocks (applying many options and conditions) from those who are not members of the exchange (Griffin, 2008). These orders follow different strategies considering many factors (e.g.: company performance, speculation, industry trends, and market trends) 1

4 2. Discuss the arguments for and against stock options. Why are they deemed to be a desirable form of executive compensation? Why are they sometimes considered just the opposite? Stock options are an arrangement by which an employee receives the option, or right, to buy shares for a specified price during a specified time. Options are granted to an individual at the given price and can be exercised at any time during the agreed-upon term. For instance, the employees may wait until the company has gone public and the shares have risen before they choose to buy the stocks in the option plan at the original set price (Widener, 2006). In this way the employee can make a substantial gain; but some concerns have risen over the years showing that this option also presents some disadvantages. The most important advantages and the reason for what they are deemed to be a desirable from of executive compensation are the employee connection with the company (they offer to executives an opportunity to have ownership in the company where they work), the financial benefits (executives can get some financial benefits), saving plan, rewarding investment in a long-term financial strategy, cost awareness (executives come more cost- and profit-conscious), attraction (this option could attract more people to the company), liquidity (the company remain more liquid because is compensating by stocks), and it can offer tax benefits (an incentive stock option allows to executives avoid paying taxes on the stock until the shares are sold). In other hand, stock options present some disadvantages. The more important are potential excessive risk (stock options may encourage executives to take excessive risks (Kim, Nam, & 2

5 Thornton, 2007)), merge increase (as option pay increases, companies engage in more merger and acquisition activities and spend less on other investments (e.g.: R&D)), investment diversification (to diversify their investments and minimize their personal risks, executives often exercise shares generated from stock options to lock in any gains (Kim, 2007)), macroeconomics factor (much of the stock price appreciation can be attributed to industry or macroeconomics factors, not executive performance), lack of threshold, increase unethical actions (unmeasured ambition making money could motivate to executives cross ethical barriers), dilution (if this option is given to many people, the value of the stock can be diluted), and discoursing factor (shares could not increase in value instead of the valuable job developed by the executives, discouraging them). 3. Using the information on securities (stocks and bonds), design a compensation method to reward performance using securities in a way that does not encourage the excesses of the present system of stock options. For avoiding more of the disadvantages of the stock option, a performance and periodic threshold is appropriates to establish. This means that in addition to the current scheme that the company has to compensate executives, we could add a premium-priced stock option. This option builds a performance threshold into the equation by making the exercise price greater than the stock price at the time of grant. If the stock does not exceed the performance threshold, there is no benefit. Thus, premium-priced stock options have a greater potential benefit and a greater potential risk for participants. Guidry et al. (Guidry, Leone, & Rock, 1999) discuss the design of the stock option bonus plan. They define and optimize a payoff function establishing the range of work. Finding the 3

6 optimal function, they state Detecting this relation is complicated by the design of the typical bonus plan. In the typical plan, performance must exceed a threshold for the executive to receive a payment. This feature adds convexity to the payoff function, and gives the manager an incentive to increase risk. The typical plan also has a cap on the maximum payment. This feature adds concavity to the payoff function, and gives the manager an incentive to use derivatives to reduce risk. Thus, the expected relation between bonus plans and the use of derivatives depends on which region of the payoff function, convex or concave, is of more concern to the manager. In addition, the stock option should not available for people in those divisions that have a control responsibility in the company. The objective of this requirement is to avoid unethical behaviors. In this way, executives and controllers work separately. 4. You are an executive of a major corporation. In the present economic times, would you be prepared to accept stock options as part of your compensation package? Give your reasons listing any implications that might arise from your position. This current economic times offer an incredible opportunity for many industries and their executives as well as difficult times for other ones. The first reason influencing any decision about to accept or not stock options depends strongly of the business that the company is developing. For example, all industries related with energy (e.g.: electricity generation, oil and gas, including their production, transportation and distribution) seems that they will be very favored in coming years. In addition, if these companies are related with greener energy business, the opportunities look higher. 4

7 The second reason is the forecast of the business, sector, regulations, etc. Following with the example in the energy industry, instead of the energy sector appear to be a very profitable business in coming years, regulations about gas emissions could hurt certain particular industry (e.g.: Coal Power Plants), or production forecast could expose the weakness of some industry in the medium and long-term (e.g.: Natural Gas in Alberta). Finally, one of the most important reasons is related with the prescription that bonuses should be based on objectives that can be achieved with reasonable efforts. The current economic time situation will change, the forecast (and also the past and present of the company numbers) of these changes should match with the effort that it is necessary to develop in achieving the targets. This point could mean hard negotiations establishing the better forecast as well as clauses to deal with. Works consulted Griffin, R., Ebert R., & Starke, F. (2008). Business (6 th Canadian Ed.). Toronto, Canada: Person Canada Inc. Guidry, F., Leone, A., & Rock, S. (1999) Earnings-based bonus plans and earnings management by business-unit managers. Journal of Accounting and Economics Kim, Y., Nam, Y., & Thornton, J. (2007). The effect of managerial bonus plans on corporate derivatives usage. Journal of Multinational Financial Management 18, Widener, S. (2006) Human capital, pay structure, and the use of performance measures in bonus compensation. Management Accounting Research