Black-Scholes Valuations

INTRODUCTION

The year 2002 was tumultuous for U.S. businesses.

On top of the terrorist attacks and threats, there was an economic downturn after 10 years of prosperity.

In addition, widespread scandal in corporate governance was revealed. The demise of Enron, Worldcom, and others brought to light widespread accounting irregularities that had inflated profits during the previous 5 years.

These events cast a shadow over the image of business and resulted in a lack of trust on the public's part.

Stock Options

So, what are some of the issues? There seem to be two major areas of concern. First is the issue of corporate governance and board independence, and the second issue pertains to changes in accounting procedures – particularly regarding the expensing of stock options.

The passage of the Sarbanes-Oxley Act in 2002 opened the floodgates of executive compensation reform with several far-reaching actions in 2003 and 2004 that changed the regulatory landscape dramatically. The Sarbanes-Oxley legislation generally establishes guidelines and regulations to ensure the independence of the Board of Directors and the reasonableness of executive compensation.

In 2004, several legislative actions were taken to impose new taxes and constraints on deferred compensation. An early version of the legislation, the Jumpstart Our Business Strength Act (JOBS), was passed by the Senate to tighten rules on deferred compensation and impose potential penalties for non-compliance. Shortly afterward, the House of Representatives passed the American Jobs Creation Act which required that deferred compensation be taxed on a current basis unless certain requirements were met. Ultimately, Congress agreed upon the American Jobs Creation Act of 2004.

The American Jobs Creation Act of 2004 significantly changed the requirements that must be met by deferred compensation arrangements to avoid immediate taxation and potential penalties. Section 409A of the Internal Revenue Code was created by the Act under which a variety of compensation arrangements are swept into the definition of “non-qualified deferred compensation.” Stock options were directly affected by this legislation in the following ways:

• Discount stock options, or options where the exercise price is less than the market price at grant, are subject to Section 409A.
• Stock options on employer stock with an exercise price at least equal to fair market value on grant date are not subject to Section 409A.

In 2004, the Financial Accounting Standards Board (FASB) finalized rules which took effect in mid-2005 imposing the requirement that an explicit expense be recognized in the income statement for stock options going forward, where it was optional in the past. The rules require that total compensation expense must be based upon the fair value of the options, on the grant date, that are expected to vest. No adjustments may be made after the grant date in response to subsequent changes in the stock price. Fair value may be estimated using Black-Scholes or binomial option-pricing models.

Course Overview

This course first looks at the role of stock options in compensation packages. Then we show you how to place a value on these options, using the widely accepted Black-Scholes method. After explaining the elements of this formula, we teach you how to make straight-forward estimates, using an online calculator.

Finally, we will look at the future of stock options:

• Will businesses continue to offer stock options to attract top professional management?
• Will the number of stock options granted in the future be greatly reduced?
• What is the most reliable valuation method that may be used?