Question

Harmer Inc. is now a successful company. In the early days (before it became profitable), it issued ISOs to its employees. Now Harmer is trying to decide whether to issue NQOs or ISOs to its employees. Initially, Harmer would like to give each employee 20 options (each option allows the employee to acquire one share of Harmer stock). For purposes of this problem, assume that the options are exercised in three years (three years from now) and that the underlying stock is sold in five years (five years from now). Assume that taxes are paid at the same time the income generating the tax is recognized. Also assume the following facts: (Leave no answer blank. Enter zero if applicable.)

• The after-tax discount rate for both Harmer Inc. and its employees is 10 percent.
• The Corporate tax rate is 21 percent.
• The Personal (employee) ordinary income rate is 37 percent.
• The Personal (employee) long-term capital gains rate is 20 percent.
• The Exercise price of the options is $7.
• The Market price of Harmer at date of grant is $5.
• The Market price of Harmer at date of exercise is $25.
• The Market price of Harmer at date of sale is $35.

Answer the following questions:

Problem 12-32 Part b

b. Assuming Harmer issues NQOs, what is Harmer’s tax benefit from the options for each employee in the year each employee exercises the NQOs? (Round your final answer to nearest whole dollar amount.)

c. Assuming Harmer issues ISOs, what is the tax benefit to Harmer in the year the ISOs are exercised?

d. Which type of option plan should Harmer’s employees prefer?

e. What is the present value of each employee’s after-tax cash flows from year 1 through year 5 if the employees receive ISOs? Use Exhibit 3.1. (Round your intermediate calculations and final anwser to 2 decimal places.)

f. What is the present value of each employee’s after-tax cash flows from year 1 through year 5 if the employees receive NQOs? Use Exhibit 3.1. (Round your intermediate calculations and final anwser to 2 decimal places.)

g. How many NQOs would Harmer have to grant to keep its employees indifferent between NQOs and 20 ISOs? (Do not round intermediate calculations. Round up your final answer to the next whole number.)

Answer 1

Answer b.

Harmer’s per employee tax benefit upon exercise of the NQOs is, calculated below:

Amount of Shares acquired-----------------$20

Strike price---------------------------------------$7

Cash needed to exercise---------------------$140(20 * 7)

Market price--------------------------------------$25

Market value of shares------------------------$500(20 * 25)

Bargain Element--------------------------------$360(market value minus cash needed to exercise)

Marginal Tax Rate-------------------------------21%

Tax benefit in year of exercise------------$76(360 * 21%)

Answer c.

Harmer’s per employee tax benefit upon exercise of the ISOs will be $0. This is because in case of an ISO exercise, the employers are entitled to no deduction.

Answer d.

The plan that Harmer’s employees should prefer is ISOs because in this case, the bargain element isn’t taxed upon exercise; which creates tax deferral. Also, if they are held for more than one year after exercise, then in this case the entire amount will be taxed at the preferential capital gains rates

Answer e.

The present value of ISOs to each employee is calculated below:

cash needed to exercise = $140 (calculated in part b)

present value factor for 10% for 3 years = 0.751

present value of cash to exercise = $140 * 0.751 = $105.14

Shares acquired----------------------------------20

Market price at sale-----------------------------$35

amount realized----------------------------------$700(20 * 35)

Basis in stock-------------------------------------$140

long term capital gain---------------------------$560(700 - 140)

marginal tax rate----------------------------------20%

Tax paid on capital gain during sale----------$112(560 * 20 %)

Net cash inflow------------------------------------$588 (700 - 112)

present value factor for 10% for 5 years----0.621

Present value of sale proceeds---------------$365.14

Present value of ISOs-------------------------$260 ($365.14 - $105.14)

Note: As per policy, first 4 sub parts are answered. Thank you!