1. Why do companies use stock options to compensate employees? What are the advantages of stock options relative to cash compensation? What, if any, are their disadvantages? 2. What, if any, risks do Dell’s shareholders face from Dell’s stock option program? Draw terminal payoff diagrams to illustrate the risk. Is this risk something that shareholders of Dell expect to bear when investing in Dell? 3. How does Dell remove, or hedge, the perceived risk of the stock options program for shareholders? Draw terminal payoff diagrams to illustrate. 4. Why does Dell transact in both call and put options? Use put-call parity to reformulate the put and call positions that Dell takes in terms of Dell’s stock and borrowing. What effectively does Dell’s call and put positions accomplish? Is risk management the primary motivation for Dell’s actions?
A stock option is an offer by a company that gives employees the right to buy a specified number of shares in the company at an agreed upon price (usually lower than market) by a specific date. The benefit of granting options to employees is viewed as a good thing because it (theoretically) aligned the interests of the employees (normally the key executives) with those of the common shareholders. If a material portion of a CEO’s salary were in the form of options, she or he would be incited to manage the company well, resulting in a higher stock price over the long term. The higher stock price would benefit both the executives and the common shareholders. Substituting options is supposed to keep executives eyes on the long term since the potential benefit (higher stock prices) would increase over time. Also, options programs require a vesting period (generally several years) before the employee can actually exercise the options.
This is in contrast to a “traditional” compensation program, which is based upon meeting quarterly performance targets, but these may not be in the best interests of the common shareholders. For example, a CEO who could get a cash bonus based on earnings growth may be incited to delay spending money on marketing or research and development projects. Doing so would meet the short-term performance targets at the expense of a company’s long-term growth potential.
Stock options creates a financial stake of employees in the firms growth. The executive stock options allows the employees to participate in the upside performance of the firms, incenting them to work harder. Although there is a cost associated with the use of employee stock options. The equity holders do not earn same level of returns as they would have if the firm would not have issued executive stock options to its employee.
This loss of return in the form of dilution is the cost that equity holders have to pay for having the employee stock option program. However, this cost is mitigated by the fact that if the market value of the firm’s asset decreases, the employee shares the downside as well, thereby absorbing some of the impact of the market value decrease from equity holders. Another cost that the equity shareholders bear is the liquidity cost. The employees are usually paid a higher market value of stock options then they would otherwise receive solely through wages due to the fact that the options they received cannot be traded or realized until a particular date. The use of executive stock options transfer some of the market risk from the equity holders to the employees thereby reducing the beta of the equity.
At the time of case, companies are not required to report any compensation expense in their publicly filed financial statements when they grant stock options. However, when certain options are exercised, companies receive a tax deduction, which can provide significant income tax savings.
There are two arguments that you’ll commonly find against the use of stock options: Dilution of ownership and overstatement of operating income.
When an employee exercises her stock options, the company has to either issue new shares or go out on the open market and purchase shares. If new shares are issued, then your ownership is diluted. If the company purchases shares on the open market, then the company, which only receives the exercise price from the employee, has to pay market price for the shares it purchases. This results in a net cash outflow for the company.
Since the impact of the compensation deduction that a corporation can claim for tax purposes is not included in a company’s GAAP income, many take the view that using options enables the company to overstate its income.
Risks to Dell shareholders: Dell Share holders bear the risk in the form of cost of potentially issuing the stock at below market values if the employees do convert the options into stock when the options are in-the-money. However, if the options expires out of the money, the shareholders realize equally better benefits. In this case, the firm obtains labor from employees without having paid for the labor by issuing shares. The employee stock options provides a cushioning from the full burnt of the downside of a firms poor performance while taking a share of the upside benefits also. There is essentially a risk transfer from shareholders to employees through the use of employee stock options. The share holders pay a fair cost to incent employees to be more productive. The executive stock options seem to counteract some of the risk that shareholders naturally bear when they buy a stock.
Hedging the risk of Stock options: By issuing employee stock options, Dell presumably takes a short call position on its stock thereby creating a liability to be paid in future. (Appendix shows the payoff diagram of Dell’s liability because of the employee stock option program.) To hedge the risk associated with the liability Dell is purchasing a 2.8 M call options. This effectively hedges the risk of the executive stock option program back to the shareholders.
Dell by engaging in the put and call options is basically equivalent to buying a forward contract on its own stock. With the share repurchase program, Dell is also pursuing a strategy of having long call and short put position. Using the put-call parity, (Appendix) the long call and short put transaction is equivalent to buying stock by borrowing money. So dell’s long call and short put transaction is equivalent to a levered share repurchase. As a result of the above transaction the risk of having a combination of long call and short put is higher then that of just having a long call position (employee stock option program), which is transferred to dell shareholders. In this case dell is hedging the risk in the same way as a levered share repurchase program would work by creating more value to the shareholders by increasing the risk borne.
I had completed the analysis of the Dell’s proposed stock repurchase program for upto 12 Million shares and the use of the equity options as part of the repurchase. As per the information available the put-call transactions along the share repurchase program being employed by Dell would create substantial value for the firm and the shareholders only if management has private information that Dell stock is undervalued and would perform above expectations in the coming months.