Exotic Cuisines For A New Graduate In Management

Exotic Cuisinesas A New Graduate You Have Taken A Management Position

Exotic Cuisines as 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 thought. During your interview process, one of the benefits mentioned was employee stock options. Upon 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. Exotic 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 has a yield of 4.4 percent.

Paper For Above instruction

Valuation of Employee Stock Options Using the Black-Scholes Model and Strategic Considerations

Introduction

Employee stock options (ESOs) are a common form of compensation used by companies to attract and retain talent, incentivize performance, and align employee interests with those of shareholders. The valuation of these options, especially when they are not transferable or tradable, is complex and influenced by various factors including volatility, time to maturity, and exercise restrictions. This paper discusses the application of the Black-Scholes-Merton (BSM) model to value employee stock options, examines strategic exercise decisions, and evaluates the implications of market risks and corporate practices such as repricing. Additionally, it reflects on the potential improvements in ESO structures to mitigate systematic market risk effects.

Valuing Employee Stock Options with Black-Scholes

The Black-Scholes-Merton model is a widely accepted analytical framework for valuing European-style options, which aligns with the initial vesting period of Exotic Cuisines' stock options. The key variables in the model include current stock price (S), strike price (K), risk-free rate (r), time to maturity (T), and volatility (σ). Given the specifics, the current stock price is $24.38, the strike price is $50, and the risk-free rates are 3.8% for three years and 4.4% for ten years.

For valuation purposes, the three-year and ten-year risk-free rates are used as T in the model. The volatility (σ) is estimated at 60%, reflecting the higher uncertainty associated with a young restaurant chain. Using these inputs, the BSM model calculations indicate that the options are deeply out of the money at present, which significantly affects their fair value.

Decision at the 3-Year Stock Price Increase

If, after three years, the company’s stock price rises to $60, a critical decision must be made: whether to exercise the options immediately or hold them further. Several determinants influence this choice, including the intrinsic value of the options, expectations of future stock performance, liquidity preferences, and tax considerations. Exercising at $60 grants an intrinsic value of $10 per share ($60 - $50), totaling $100,000. If the stock is expected to appreciate further, it might be more advantageous to hold the options, especially given the 10-year expiration period, unless immediate liquidity or tax planning considerations suggest otherwise.

Impact of Non-transferability on Valuation

Employee stock options are generally non-transferable and non-tradable, which significantly affects their valuation. Unlike exchange-traded options, where the marketability premium is incorporated, non-transferable options are less liquid, and their value must be adjusted downward to reflect the lack of marketability. According to some valuation models (e.g., restricted stock models), the absence of transferability can reduce the option’s value by approximately 20-30%. This discount recognizes that employees cannot hedge their positions, thus increasing their risk exposure, which decreases the option's attractiveness to potential holders.

Vesting Provisions and Post-Employment Exercise

Vesting provisions serve as a mechanism to motivate continued employment and performance. They also serve to retain talent by tying the potential financial benefit to ongoing service. Once options vest, employees delay exercising temporarily due to strategic considerations, including tax implications and future growth expectations. The requirement to exercise within 90 days after leaving ensures that the options are not transferred or held indefinitely, maintaining the company’s control over ownership and aligning with tax regulations. Short exercise windows post-termination prevent the proliferation of unexercised options and mitigate potential abuse.

Repricing of Employee Stock Options

Repricing involves lowering the strike price of underwater options when the stock declines significantly, thus restoring their value. Supporters argue that repricing motivates employees by preventing their options from becoming worthless, thus maintaining motivation and reducing turnover. Opponents contend that it rewards failure, undermines shareholder confidence, and may encourage management to avoid accountability. From a valuation standpoint, the possibility of repricing during the grant or afterward can significantly increase the initial fair value of options because it reduces downside risk. However, this practice can distort motivation by diminishing the alignment between employee incentives and shareholder value.

Implications of Systematic Market Risks and Proposed Improvements

Systematic risks, such as market-wide downturns, impact stock prices beyond company-specific factors. For employees holding options, these risks imply that even good performance may not translate into option value if the market declines. This disconnect emphasizes the importance of designing incentive plans that mitigate the adverse effects of systematic risks.

One potential improvement is the introduction of hybrid options or real options that incorporate downside protection or dividend-like features. For example, implementing stock appreciation rights (SARs) or using options with caps and floors can help employees participate in upside rewards while limiting downside exposure. Additionally, companies might consider offering equity-linked bonus plans or performance shares that are less sensitive to market volatility and systematic risk.

Conclusion

Valuing employee stock options accurately requires comprehensive understanding of market variables, corporate policies, and strategic implications. The Black-Scholes model provides a useful framework but must be adjusted for factors like lack of transferability and market risk. While practices like repricing can maintain motivation, they also raise ethical concerns and may influence the perceived fairness of compensation schemes. Moving toward more sophisticated, risk-mitigating incentive plans can better align employee interests with long-term shareholder value, especially in volatile industries like restaurants.

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