Page 427 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 413

Black- Capital Minimum
Symbol Definition Binomial Scholes Assets Value
S Stock price x x x x

q Dividend yield x x x
t Time in years to expiration x x x x
β Beta (volatility) x x

x Exercise price x x x x

r Risk-free rate of return x x x x
σ Standard deviation x

Table 8-5. Option pricing models compared

Impact on Value of Option
Option Pricing Variables
Based on Direction of Change
1. Option exercise price Inverse
2. Length of stock option term Direct
3. Stock price market value Direct
4. Stock volatility Direct
5. Dividend yield Inverse
6. Risk-free rate of return Direct
Table 8-6. Impact of pricing variable on option value

Namely, if the value increases, so does the option value; if it decreases, so does the option
value. Therefore, several ways in which to lower the expense on the option are to: shorten
the term of the grant (e.g., five years instead of 10), lower the volatility (if defensible), and
increase the dividend (high dividends leave less many available to by back stock). But many
will argue that the true expense is not known until the option is exercised (at which time it
will equal the tax deduction). Stock option pricing models are most likely to overstate the
value of a stock option in a declining stock market, especially when the far market value falls
below option price.
In 2007 the SEC approved an auction system designed by Zlons Bancorp as an accept-
able method for determining the market value for an employee stock option and an accept-
able substitute for formulas such as Black-Scholes. The auction method requires a public auc-
tions where sophisticated investors are offered the opportunity to purchase stock options that
are the mirror image of stock options offered to company employees. This method is very
similar to a market-based system developed by Cisco Systems in 2005 which they called Esors
(employee stock option reference securities). But Esors were not approved by the SEC as an
acceptable alternative to Black-Scholes and other internal models. These SEC actions
suggests that companies wishing to use this approach will want to review the specifics