Employee Stock Options

Part 8 – Employee Stock Options

In our last tutorial, we have understood convertible features. In this article, we will learn about employee stock options.

Step 8: Calculate ‘in the money” stock options

Apart from the capital structure stated above, ABC has also issued employee Stock Options as per below.

What are employee stock options?

An employee stock option is a call option on the common stock of a company, issued as a form of non-cash compensation. Restrictions on the option (such as vesting and limited transferability) attempt to align the holder’s interest with those of the business‘ shareholders. If the company’s stock rises, holders of options generally experience a direct financial benefit. This gives employees an incentive to behave in ways that will boost the company’s stock price.

Employee stock options are mostly offered to management as part of their executive compensation package. However, they may also be offered to non-executive level staff, especially by businesses that are not yet profitable, insofar as they may have few other means of compensation. Alternatively, employee stock options can be offered to non-employees: suppliers, consultants, lawyers, and promoters for services rendered. Employee stock options are similar to warrants, which are call options issued by a company with respect to its own stock.

Treasury Stock Method for calculating the additional number of shares issued.

This method assumes that a company’s proceeds from an in-the-money option exercise are used to repurchase common shares in the market. In order to comply with generally accepted accounting principles (GAAP), the treasury stock method must be used by a company when computing its diluted earnings per share (EPS).

The net of new shares that are potentially created is calculated by taking the number of shares that the in-the-money options purchase, then subtracting the number of common shares that the company can purchase from the market with the option proceeds. This adds to the total number of shares in the denominator and lowers the EPS number.

For example, assume that a company currently has in-the-money options that cover 10,000 shares with an exercise price of $50. If the current market price is $100, the options are in the money and, based on the treasury method, need to be added to the diluted EPS denominator. The proceeds the company will receive will be $500,000 ($50 x 10,000), which allows them to repurchase 5,000 shares on the market ($500,000/$100). Therefore, the net of new shares is 5,000 (10,000 option shares – 5,000 repurchased shares).

Why options exercisable is used for Treasury stock method

When employees are given stock options or restricted stock, they often do not gain control over the stock or options for a period of time. This period is known as the vesting period and is usually 3 to 5 years. During the vesting period, the employee cannot sell or transfer the stock or options. As a result, the total options issued are known as Options Outstanding. However, after the vesting period, an employee can sell their stock options which are known as Options Exercisable. Hence, an analysis should contain only those stock options that an employee can exercise and convert into shares (Options Exercisable).

In ABC, calculations of in-the-money options done using Options Exercisable is shown below.

From the above table, Net 0.70 million shares are issued because of Stock Options. 

Use Exchange rate $1=Rs46

Equity

Debt

Total Capital = Debt + Equity

Total Capital = 220.0 + 106.4 = 326.4

In this article, we have understood the basis for the calculation of the Weighted Average Cost of Capital (WACC). we will take a detailed video of WACC in our next article. Till then, Happy Learning!

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