Sally Jameson: Valuing Stock Options in a Compensation Package (Abridged)

Sally Jameson: Valuing Stock Options in a Compensation Package (Abridged) Sally Jameson, a second-year MBA student at Harvard Business School, was thrilled but confused. It was late May 1992, graduation was approaching, and she had finally landed the job of her choice. She had just finished an early morning telephone conversation with Bob Marks, the MBA recruiting coordinator at Telstar Communications, a large, publicly held multinational company. Mr. Mark had offered Ms.Jameson a unique position in operations at Telstar, and from the description, it sounded exactly like the job that she wanted Since her first interview with Telstar, she had been very impressed with the company and its people while Ms. Jameson was certain that she would accept the job, there was still one unsettled, yes crucial, matter—her compensation. During the conversation with Marks, Jameson had asked what her compensation package would be Marks: â€Å"Well, Sally, we are all very impressed with you and would like to offer you a starting salary of 50,000.In addition, you will also, receive a signing bonus† Jameson: â€Å"that has salary is a little below what I had expected. Is that negotiable? † Marks: â€Å"I’m afraid not. That’s the same starting package all MBAs get However, you will receive a bonus upon accepting our offer. You can receive $5,000 in cash, or choose stock option instead. Jameson: †I’m not too familiar with stock options. Could you explain to me what they are? † Marks: â€Å"Sure. Executives at Telstar have been eligible to receive stock options for years. The goal was to tie management’s compensation more closely to increases in shareholder value.Although our stock has performed erratically over the last ten years, the board continues to believe that stock options are the best form of incentive compensation. Because the options represent the right to buy Telstar stock at a set price, after a set period of t ime, management has an incentive to take actions to move the stock price upward. Several months ago, we had a consulting firm examine our compensation structure. They recommended that we extend eligibility for stock options to all employees as part of our new inventive-based compensation plans.Thus, the two MBAs that we hope to hire this year will be the first employees who will be offered stock options. Given that this is an experiment, we decided to give MBAs a choice between cash or options. Jameson: â€Å"How much are these options worth? † Marks: â€Å"To tell you the truth, I’m not really sure. All I know are the details: each of the 3,000 options you’ll be granted allows you to buy one share of Telstar stock at $3500 per share at the time of your fifth anniversary with the furn. Yesterday, our stock, which pays no dividend and is not expected to pay one in the foreseeable future, closed at $1875. hould you leave any point before you fifth year, you lose the options. You can’t take them with you. Casewriter’s note: stock options of this sort would more typically have been written with a strike price equal to or just slightly above the current price. Professor peter Tufano and Research Associate Michael Lewittes prepared this case. HBS cased are developed solely as the basis for class discussion. Certain details have been disguised Cased are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.Copyright 1993 President and Fellows of Harvard College To order copies or request permission to produce material, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go th http://www hbsp Harvard edu. No part of this publication may be reproduced, stored in a retrieval system, used in spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permis sion of Harvard Business School I have been told by our legal staff that these incentive stock options meet the IRS code for special treatment—that means you won’t pay any taxes on the options until you actually exercise them and then sell the shares. At that point, you gains on the shares(equal to the difference between their fair market value at that time and $3500) will be taxed at either ordinary tax rates or at capital gains rates, depending on whether you’ve held the stock for less than or more than one year after exercising the option.If you choose the cash signing bonus, it is taxed at ordinary tax rate? It’s your choice, Sally, but just between you and me, I’d take the case bonus. Telstar stock is only at $1875; it doesn’t seem to me that these options are worthe the paper thatr they’re printed on I think it’s just another example of consultants trying to justify their fees. You do what you think it best; either way, t hough, I need to know by tomorrow if you accept the offer and, if you do, which compensation package you’d prefer â€Å"While Bob Marks seemed to prefer the cash bonus, Sally Jameson was less sure. Taking out her Wall Street Journal, she noticed that both short-term and long-term. Telstar options were traded (seed Exhibit 1). Form an online financial database, she got a graph of Telstar’s common stock price and a plot of the historical volatility of the stock price as measured by the annualized standard deviation of the stock’s returns (see Exhibits 2 and 3). She also found data on government bill, note, and bond yields that would be useful in her analysis (see Exhibit 4).As she thought about the problem, she decided to approach it in two steps: first, she would attempt to determine what the options were worth, assuming she stayed at Telstar for at least five years. Then, she would consider other issues, including the likelihood that she might not stay at Telst ar that long.