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 a a. Considering these facts, which type of option plan, NQO or ISO, should Harmer Inc. prefer?

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.)

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

Part A

NQO

Tax benefit is the important consideration to take this decision. On NQOs tax benefit is earned by profitable companies which is equal to the the employee’s bargain element upon exercise. On the other hand, there is no tax benefit in case of ISOs.

Part B

Description	Amount	Explanation
(1) Shares acquired	20	(20 x 1 shares)
(2) Exercise price	7
(3) Cash needed to exercise	140	(1) × (2)
(4) Market price	25
(5) Market value of shares	500	(1) × (4)
(6) Bargain Element	360	(5) – (3)
(7) Marginal Tax Rate	21%
Tax benefit in year of exercise	$76	(6) × (7)

Part E

Description	Amount	Explanation
(1) Shares acquired	20	(20 x 1 shares)
(2) Exercise price	7
(3) Cash needed to exercise	140	(1) × (2)
(4)Present Value Factor	0.751	10% discount rate for 3 years
(5) Present Value of Cash to Exercise	105.14	(3) x (4)
Description	Amount	Explanation
(6) Shares acquired	20	(20 x 1 shares)
(7) Market Price at Sale	$35.00
(8) Amount Realized	700	(6) x (7)
(9) Basis in Stock	140	(3)
(10) Long-term capital gain	$560	(8) - (9)
(11)Marginal Tax Rate	20%
(12) Tax paid on capital gain in year of sale	112	(10) x (11)
(13) Net cash inflow at sale	588	(8) - (12)
(14)Present Value Factor	0.621	10% discount rate for 5 years
(15) Present Value of Sale Proceeds	365.15	(13) x (14)
Present Value of ISOs	260.01	(15)- (5)

Part F

Description	Amount	Explanation
(1) Shares acquired	20	(20 x 1 shares)
(2) Exercise price	7
(3) Cash needed to exercise	140	(1) × (2)
(4) Market price	25
(5) Market value of shares	500	(1) × (4)
(6) Bargain Element	360	(5) – (3)
(7) Marginal Tax Rate	37%
(8) Tax paidon bargain element in year of exercise	133.20	(6) x (7)
(9) Cash outflows at exercise date	273.20	(3)+(8)
(10)Present Value Factor	0.751	10% discount rate for 3 years
(11) Present Value of Cash to Exercise	205.17	(9) x (10)
Description	Amount	Explanation
(12) Shares acquired	20	(20 x 1 shares)
(13) Market Price at Sale	$35.00
(14) Amount Realized	700	(12) x (13)
(15) Basis in Stock	500	(5)
(16) Long-term capital gain	200	(14)-(15)
(17)Marginal Tax Rate	20%
(18) Tax paid on capital gain in year of sale	40	(16) x (17)
(19) Net cash inflow at sale	660	(14) - (18)
(20)Present Value Factor	0.621	10% discount rate for 5 years
(21) Present Value of Sale Proceeds	409.86	(19) x (20)
Present Value of NQOs	204.69	(21)- (11)

Part G

Description	Amount	Explanation
(1) PV of ISOs	260.01
(2) PV of NQOs	204.69
(3) Ratio	1.270	(1 / 2)
(4)ISOs received	20
(5) NQOs to break even with ISOs	25.4	(3) x (5)
NQOs to be received	26	Rounded