6Dilut Sec OptionsSu2006

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Published on February 24, 2008

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POTENTIALLY DILUTIVE SECURITIES:  POTENTIALLY DILUTIVE SECURITIES ACG 4133C Summer 2006 1. Dilutive Securities:  1. Dilutive Securities Dilutive Securities: Other securities that may become common stock if conditions permit (may dilute earnings per share) Convertible Bonds: Bonds which can be converted into stock at the holder’s option, during a specified period of time after issuance Combines the benefits of a bond with the attractive privilege of exchanging it for stock Lower interest rate than regular bonds 2. Convertible Debt:  4 Accounted for as pure debt at issuance -- APB Opinion 14 assumes that the debt and equity features inseparable 2. Convertible Debt Cash $ Discount (if any) $ Bonds Payable $ Premium (if any) $ There is no separate account (or valuation) for the conversion feature. 3. Convertible Debt:  3. Convertible Debt Analysis: FASB maintains that there is no value for the conversion feature. Is this presumption correct from an economic stand-point? It costs the firm less to issue convertible debt. What does this fact imply? 4. Convertible Debt:  7 Book Value Approach: Most commonly used method, also GAAP. At issuance, same entries as straight debt At conversion, use book value of bonds to value shares issued (continuation of single transaction) Assume B/P carrying value is $80,000; redeemed when market value of bonds is $82,000 and market value of shares is $85,000. 4. Convertible Debt Bonds Payable 80,000 Common Stock 80,000 5. Convertible Debt:  8 5. Convertible Debt Induced conversions (sweetener) “Sweetener” is an expense of the period To induce conversion of the above bonds the corporation offers $3,000, cash. Book value method **FASB #4 indicates that sweeteners are not a reduction of acquired capital Bonds Payable (net) 80,000 Debt Conversion Expense** 3,000 Contributed Capital 80,000 Cash 3,000 6. Convertible Preferred Stock:  10 6. Convertible Preferred Stock Conversion of preferred stock to common stock Issuance and conversion handled in similar manner Book value method Preferred Stock XX Paid in Capital, P/S, if any XX RE to balance (if needed)1 XX Common Stock XX Paid in Capital, C/S (to balance)2 XX 1Book value of preferred less than par value of common (rare) 2Book value of preferred exceeds par value of common 7. Example: Firm issues 1,000 shares of 8% $100 par preferred stock for $160,000. They are convertible into 2,000 shares of $10 par common stock.:  7. Example: Firm issues 1,000 shares of 8% $100 par preferred stock for $160,000. They are convertible into 2,000 shares of $10 par common stock. At date of issue: Cash Dr160,000 Pref. Stock Cr 100,000 APIC- P/S Cr 60,000 At date of conversion: APIC- P/S Dr 60,000 Pref. Stock Dr 100,000 Comm. Stock Cr 20,000 APIC- C/S Cr 140,000 8. Stock Warrants:  11 Stock warrants are rights entitling the holder to acquire shares of stock at a certain price within a certain time period May be issued with other securities to make the securities more attractive Issued as evidence of the pre-emptive right. Issued as compensation to employees. Detachable stock warrants: Issued with other securities. Can be traded separately, hence have separate value. 8. Stock Warrants 9. Detachable Stock Warrants:  12 9. Detachable Stock Warrants Issued with other securities. Equity feature and debt feature accounted for separately as per APB Opinion 14. Two methods: Proportional Method (Relative FMV): FMV Purchase cost Carrying Value C/S $8,000 (8/11) $10,000 $7,273 Warrants 3,000 (3/11) 10,000 2,727 Incremental method: Used when only one security has a market value. Assume in this case only value of common is known. Received $10,000 for both. Allocate $8,000 to common stock. Allocate the remainder $2,000 to warrants If neither has a FMV then Board of Directors will set a value. 10. DEBT WITH WARRANTS -- EXAMPLE:  10. DEBT WITH WARRANTS -- EXAMPLE Leo Co. issued $200,000, 8% bonds with detachable warrants at $205,000. Each $1,000 bond has 20 detachable warrants. Two warrants and $20 cash can be used to purchase one share of Leo’s $10 par value common stock. The warrants themselves sell in the market for $2 each. Provide entry at issue date. 11. Example:Solution:  11. Example:Solution Issue Date: (Only incremental method possible. Why?) 12. Detachable Warrants Example Solution:  12. Detachable Warrants Example Solution If 3000 warrants exercised: If 1,000 warrants lapse: 13. Stock Warrants:  13 Non-Detachable warrants Issued in conjunction with, but not separately from, debt securities. Treated as “straight debt”. Analogous treatment to convertible debt. 13. Stock Warrants 14. Stock Rights:  14 14. Stock Rights Stock rights are evidence of the pre-emptive right-- issued to existing shareholders-- to buy stock to maintain percentage ownership. Tend to be short-term in duration. Memo entry only - no journal entry required until exercise (then normal entry made when stock is issued at exercise). 15. EMPLOYEE STOCK OPTIONS:  15. EMPLOYEE STOCK OPTIONS Another form of warrant which gives selected employees the option to purchase common stock at a given price over an extended period of time Used to compensate and motivate employees towards actions that lead to high profitability Questions: How to measure the value of S/O and related compensation costs? Over what periods should compensation expense be allocated? 16. Compensatory versus Non-Compensatory Plans:  16 16. Compensatory versus Non-Compensatory Plans 1. Non-compensatory Plan – primary purpose is to raise capital and spread ownership, not to compensate employees. Must have all of following features: Available to substantially all full-time employees Offered equally or at least uniform percentage Discount from market price is quite small Limited (reasonable) exercise period No compensation expense for the firm No formal entry until exercised (APB Opinion #25) 17. Compensatory Plans:  16 17. Compensatory Plans 2. If any one of the above criteria is not met, the plan is compensatory (and hence non-qualified plan for tax purposes). Affords a better tax position to the issuer firm as compensation expense is tax deductible. 18. Stock Option Plans:  17 Dates: Date of Grant--When option is extended to employees Measurement Date--When total number of shares involved and the option price are both known 18. Stock Option Plans 19. Stock Option Concepts:  18 Is the plan compensatory, i.e., do executives receive economic value? (Warren Buffett…) What is the amount of value transfer to the employees, i.e., compensation cost? When should the compensation be measured? Which accounting method: “intrinsic value” or “fair value”? Dates: Grant Date -- When option is issued to employees Measurement Date --When total number of shares involved and the option exercise price are both known Which period(s) should the total compensation expense be allocated? Over service period (typically grant date to vesting date) 19. Stock Option Concepts 20. Stock-Based Compensation:  20. Stock-Based Compensation All employees eligible? Shares offered equally? Reasonable exercise period? Ex.Price at least 95% Mkt Price? No Yes Yes Yes Yes Non- compensatory Plan Record shares issued when stock is purchased. No No No Compensatory Plan Determine compensation expense; amortize over period employee is to provide service. No Grant and Measurement dates same? Yes Number of shares and Exercise Price known? Estimate compensation expense; amortize over period employee is to provide service. Determine actual expense; amortize over remaining period employee is to provide service. Record shares issued when stock is purchased. Adjust for Unearned Compensation, if any No Yes 21. STOCK OPTION EXAMPLE:  21. STOCK OPTION EXAMPLE 1/1/2000 (Grant Date) - Employees granted options to purchase 1000 shares of $10 PV common Options good for 5 years -- at grant date: market price is $30 and exercise price is $28. Fair value of options estimated at $5 each (from option model) Options exercisable 1/1/2002 if employees stay 2 years Employees purchase 600 shares on 1/1/2002 when shares have market value of $36 12/31/2004 remaining options lapse 22. INTRINSIC VALUE APPROACH:  22. INTRINSIC VALUE APPROACH Described in APB Op. 25 Companies generally prefer this approach since it usually means no expense recognized Value of option assumed equal to difference between market value of stock and exercise price at date of grant If exercise price above or equal to market value no recording of the option or compensation 23. INTRINSIC VALUE:  23. INTRINSIC VALUE Total Compensation Expense: Entry: At grant date (1/1/2000) At 12/31/2000: 24. INTRINSIC VALUE (Cont.):  24. INTRINSIC VALUE (Cont.) At 12/31/2001 (end of year 2): At 1/1/2002 (exercises options on 600 sh.): At 12/31/2004 (expiration/leave before vesting): 25. Fair Value Approach:  25. Fair Value Approach Described, recommended, but not required by FASB Statement # 123. Compromise. FASB 123R requires it but implementation delayed Companies dislike FV approach because compensation expense is recognized Option is measured as estimated fair value on date of grant An option pricing model (e.g., Black-Scholes, etc.) used for computing the fair value of the options Drawbacks of approach: No market for ESO’s (not traded options) Constraint: cannot exercise before vesting 26. FAIR VALUE APPROACH ENTRIES:  26. FAIR VALUE APPROACH ENTRIES 1/1/2000(date of grant): 12/31/2000 (end of first year): 27. Fair Value Method (Cont.):  27. Fair Value Method (Cont.) 12/31/2001 (end of second year): 1/1/2002 (exercises options on 600 shares): 12/31/2004 (expiration date) *Conceptual note: If the market price upon exercise is substantially greater than the market price on the day of grant it will result in significant unrecorded compensation to employees. 28. Disclosure of Stock Options:  28. Disclosure of Stock Options FASB allowed continued use of APB 25 approach, but required footnote disclosure of proforma NI and EPS under FV approach (compromise) Required Disclosure (intrinsic and fair value): # of options: (1) outstanding at beg. and end of year,(2) exercisable at end of year, (3) granted, exercised, and forfeited during year Weighted average exercise price of options granted Weighted average fair value of options granted 29. Chronology Surrounding FASB 123:  29. Chronology Surrounding FASB 123 June ‘93 -- FASB Exposure Draft requires fair values Opposition expressed by business community -- threat to entrepreneurship and economic recovery June 30, ‘93- senate bill introduced to mandate that SEC require that no compensation expense be reported for options Late ‘93 - all SEC commissioners express reservations about the proposed requirement Early ‘94 -- senatorial group express concern to SEC about possible congress override of FASB Mid ‘94 -- FASB agrees to 1-year delay of some provisions Late ‘94 -- FASB opts to encourage, not require, fair value Oct. ‘95 -- FASB issues Statement 123 Dec. 2004– FASB issues Statement 123R requiring fair value April 2005 – implementation delayed by SEC and FASB (due to valuation model issues) Slides 30-31 present a simple illustration of the Binomial Method of valuing stock options (Black Scholes Model is a closed-form solution under certain conditions):  Slides 30-31 present a simple illustration of the Binomial Method of valuing stock options (Black Scholes Model is a closed-form solution under certain conditions) 31. Valuing Stock Options: Black-Scholes model :  31. Valuing Stock Options: Black-Scholes model Black-Scholes model solves for a call options fair price as a function of: 1. Current stock price (+) 2. Options exercise price (-) 3. Options time to maturity (+) 4. Risk-free interest rate (+) 5. Volatility of the stock (+) [6. Expected dividends (-), for div paying stock] 32. Simplified Binomial Method of Option Pricing:  32. Simplified Binomial Method of Option Pricing Suppose QQQ Inc. shares have a current market price of $50 Options available now -- each option entitles the holder to acquire 100 shares at an exercise price of $50 per share Options only exercisable at expiration date (in one period) at which time the market price will either be $45 or $55 per share All borrowings are at 5% per period All investors (the market) agree that the fair market value of the call option is approximately $357. Huh??? (If stock price is constant at $50, the option value is $238 ) 33. The Simplified Approach:  33. The Simplified Approach The pay-off for the option at the expiration date will be: $55 price $45 price 100 shares (55-50)= $500 $0 Suppose we choose a portfolio composed of stock and debt, and that portfolio duplicates the option payoffs. That is we borrow and use the proceeds to buy QQQ shares: $55 price $45 price No. of Shares Bought x price …. …. Less: Borrowing and interest …. …. should = to $500 $0 The payoffs of the portfolio and the option should be identical -- hence if we know the value that the market places on the portfolio today, that must also be the value of the option today 34. Developing the Identical Payoff Portfolio:  34. Developing the Identical Payoff Portfolio Let : X = number of QQQ shares to be acquired Y = the amount to be borrowed (debt) At expiration date, we want: (1) $55 (X) - 1.05 (Y) = $500 (2) $45 (X) - 1.05 (Y) = $0 Subtracting (2) from (1): 10 (X) = $500 ……i.e., X (# of shares) = 50 shares Substituting in (2): $45 (50) = 1.05(Y) i.e., Y (amount to borrow) = $2142.86 35. Simplified Example: Identical Portfolio Payoffs:  35. Simplified Example: Identical Portfolio Payoffs So, if we borrow $2142.86 and purchase 50 shares our payoffs in one period’s time will duplicate those of the option. To check : In one period’s time our debt will have grown to $2,250 (the $2142.86 borrowed plus one period’s interest at 5%, $137.14). If shares then have a $45 price, they will be worth $45 times 50 = $2,250. Payoff after one period = value of shares minus debt = $2,250 - $2,250 = $0 (same as the option) If shares then have a $55 price, they will be worth $55 times 50 = $2,750. Payoff after one period = $2,750 (value of shares) minus $2,250 (debt) = $500 (same as option) 36. Valuing Stock Options:  36. Valuing Stock Options If the portfolio and the option offer identical payoffs -- they must have the same value Today (the start of the period) the market says the net value of portfolio of shares and debt is worth $357.14 (We just “acquired” 50 shares for $2500 and “borrowed” $2142.86) If the portfolio’s value today is $357.14, the market would have to agree that the option has a value of $357.14 [If we shorten the period of binomial outcomes, and increase the outcomes to many, we approach Black-Scholes model] 37.Stock Appreciation Rights (SARs):  37.Stock Appreciation Rights (SARs) For non-qualified stock options, on the date of exercise, the executive must pay cash equal to the exercise price. SAR’s are designed to avoid this cash outlay. The executive receives share appreciation (in cash or shares) on the date of exercise, rather than being issued shares in return for an exercise price. Share appreciation is difference between market price and pre-established “option” price 38.Stock Appreciation Rights (SARs):  38.Stock Appreciation Rights (SARs) EXAMPLE: Amount of compensation strictly not known until date of exercise Example: On 1/1/2005, when the company’s shares have a market value of $22 each, 1000 units of SARs issued – the service period is 3 years from issue – they vest and are exercisable on 12/31/2007 and expire on 12/31/2009. The established exercise price is $20. Appreciation to be paid in cash. 1. Can choose to follow FASB 123 guidelines and measure compensation expense at $2,000 (i.e., 1000 times $2) -- to be recognized over 3 years. 2. Alternatively, compensation expense is re-estimated each interim period, as per FASB Int # 28. (Typically followed) [Why does the FASB not apply re-estimation to stock options?] 39. Stock Appreciation Rights (SARs):  39. Stock Appreciation Rights (SARs) Example: On 1/1/2005, when the company’s shares have a market value of $22 each, 1000 units of SARs issued – the service period is 3 years from issue – they vest and are exercisable on 12/31/2007 and expire on 12/31/2009. The established exercise price is $20. Appreciation to be paid in cash. Suppose per share market value is $27 at 12/31/2005: Suppose per share market value is $23 at 12/31/2006: Estimated total compensation equals $3000 (1000 x $3). Two-thirds of this ($2,000) can be cumulatively recognized by now. So far, though, $2,333 has been recognized. 40. Stock Appreciation Rights (SARs):  40. Stock Appreciation Rights (SARs) Example: On 1/1/2005, when the company’s shares have a market value of $22 each, 1000 units of SARs issued – the service period is 3 years from issue – they vest and are exercisable on 12/31/2007 and expire on 12/31/2009. The established option price is $20. Appreciation to be paid in cash Suppose per share market value is $32 at 12/31/2007, and half of the SARs are exercised on that date: Suppose per share market value is $29 at 5/31/2008, and the remainder of the SARs are exercised on that date: 41. Stock Appreciation Rights (SARs):  41. Stock Appreciation Rights (SARs) Example: On 1/1/2005, 1000 units of SARs issued – the service period is 3 years from issue – they vest and are exercisable on 12/31/2007 and expire on 12/31/2009. The established exercise price is $50. Appreciation to be paid in cash. The per share market prices of the company’s stock are as follows: 1/1/2005 $59 12/31/2005 $74 12/31/2006 $57.20 12/31/2007 $63 5/1/2008 $64 (date of exercise of all SARs)

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