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Strategies & Market Trends : Employee Stock Options - NQSOs & ISOs -- Ignore unavailable to you. Want to Upgrade?

To: Clarksterh who wrote (145)	7/31/2002 5:43:34 PM
From: rkral	Read Replies (2) \| Respond to of 786

Clark Hare, re ... [the treasury stock method] "essentially assumes that no one ever actually exercises an option except the extent that they can get the required cash by selling the rest of the options." I don't believe that viewpoint is correct. However, it does assume that the cash flowing to stockholder equity is used to buy stock on the open market. This cash flow is from 1) the exercise price dollars from the employee, and 2) the tax credit dollars from Uncle Sam. It's the calculations using the treasury stock method that seem bizarre to me. The paper “Assessing the Cost of Stock Options - A Different View" by F.W. Cook is an example. fwcook.com All of Cook's calculation methodology can be expressed as: n = m * (1 - r) * (1 - S / P) where n = number of dilution shares, m = number of in-the-money option shares, vested and non-vested r = effective corporate tax rate S = the strike (exercise) price, and P = the stock price on the exercise date Check using Cook's example: n = 200(1-0.4)(1-10/15) = 2000.60.333 = 40 So the (1-r) term accounts for the tax benefit due to option exercise .. and the term (1-S/P) accounts for the exercise price paid to the company by the employee. Again, n = m(1-r)(1-S/P). Thus, as you said, "the dilution for an in the money option is higher for lower exercise prices", i.e., as S/P approaches zero. Other sanity checks for the equation: If the stock price equals the exercise price (S = P), then there is no dilution (n = 0) since the exercise price could pay for all m shares; If the tax rate is 100% (r = 1), there is no dilution since the tax benefit can pay for all m shares; If the tax rate is zero (r = 0) and the exercise price is much less that the stock price (S << P), then dilution is "full" (n = m). I think the treasury stock method is fair .. even though few companies actually use the generated cash flow to buy stock on the open market. Why? Because this method effectively keeps stockholder equity constant. Ron