Questions about Executive Stock Options
The date is December 31, 2004 and you have accepted a job working for Cisco, the large network equipment company. As part of the compensation package, Cisco has given you the choice of a $25000 cash bonus or call options on 50000 shares of their stock. The calls are European, and expire in 5 years. The strike price will be set at $40 per share. You have to make a decision by tomorrow which to accept.
The Canvas site contains historical information on the companys stock (symbol CSCO) and on traded options as of 12/31/2004. Another file shows interest rates on that date. Using this information, prepare a report addressing the following issues.
· Question 1. Assume the call options are just like standard exchange-traded calls, except that you are not allowed to sell them to somebody else. What are the options worth using a standard binomial model? Do you believe the model? Why or why not? Which bonus would you pick?
· Question 2.a Now assume that the company tells you that, in addition to not being able to sell them, you also cannot hedge the calls by selling short the companys stock or entering into any other economically equivalent contract. Would this change your decision?
· Question 2.b Assume that there are no restrictions or costs to selling short the stock, but the options contracts will not vest unless you are still employed by the company on the expiration date. In other words, the options are cancelled if you resign or are fired. Would you now choose the options or the cash? Explain.
· Question 3. What is the company attempting to do by offering you the options? What problem are they trying to solve with the vesting provision? Do they want you to take the options?
· Question 4. Later in 2005, Cisco came up with an original financial engineering prod- uct to try to convince accounting regulators that executive stock options should not be valued with standard options pricing models when deducting their cost from reported earnings. See the New York Times article on Compass describing their invention, called Esors. If Cisco is successful in selling the Esors, they are hoping that investors will not pay very much for them. How would this outcome affect the objectives you described in Question 3?
