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Strategies & Market Trends : Good Investment Theses: VALUATIONS w/ FUNDAMENTAL ANALYSIS -- Ignore unavailable to you. Want to Upgrade?

To: jbn3 who wrote (128)	4/28/1999 12:27:00 AM
From: Chuzzlewit	Read Replies (1) \| Respond to of 160

Good evening Bachman, You pose a complex transaction and then ask wherein do I err? I'm not sure that there is an error if we assume efficient B/S pricing. If not, then I think the error is a subtle one in that you include the method of financing the option (which may not be efficient) together with the cost. So perhaps we need to disassemble the the transaction. First, the company issues a stock option roughly analogous to a leap call, but receives no remuneration for the option. I would argue that this "simple" transaction subsumes two other transactions -- the issuance of sufficient new shares to satisfy the needs of the option holders, but in order to avoid dilution the company repurchases an identical number of shares. In previous examples I believe I showed how this cost could be calculated. You propose to finance the cost of the repurchase through a second option -- purchase of a Leap call option. I believe that in theory at least the two costs ought to be roughly the same. But exercise of the call requires cash paid out at the time of exercise. So we have the following cash flows: T0: a call is purchased --> Cash out T1: a call is exercised at strike price --> Cash Out T11: an option is exercised at conversion price --> Cash In So, the PV equals (T11-T1)/(1+i)^n-T0 where i is the discount rate and n is the number of periods. I believe that this cost will be exactly the same as predicted by the first model if the B/S option pricing model is correct. As you pointed out, that part of the analysis works only if the price of the stock rises above the striking price of the ESO. If not, then the cost will be the cost of the LEAP option plus the present value of the cost of repurchasing the stock less the present value of the strike price of the ESO. The ultimate evaluation is difficult because we have no probabilities to assign to outcomes. I agree with your assessment about when the most significant costs are incurred. The point I am unsure about is whether purchase of a call leap to hedge the ESO decreases the cost of the ESO from the model I presented. My big toe is telling me that it does not. How's that for a fancy analytical answer? TTFN, CTC