Question

Finance: Acquiring and Using Funds to Maximize Value        

Any Good Options Here?

Back in 1980, less than one-third of all chief executives working in public companies received stock options as part of their pay package. By 2006, companies granted nearly 80% of all chief executives such options. So there’s no doubt that stock options for executives have become increasingly popular over the past 25 years or so.

Then why does prominent economist and former Federal Reserve Chair Paul Volcker express his disapproval of this method of rewarding executives for performance in no uncertain terms? “I think we ought to get rid of them,” he says.

Most top-level executives receive a particular type of option called “incentive stock options” (ISO). Like all stock options, an ISO gives the executive the right to buy, or “exercise,” a specific number of shares of their company’s stock during a specified period of time at a set price (the “strike” price). The strike price is usually equal to the market value on the day the option is granted. If the market value of the stock goes up, executives makes money—in some cases, lots and lots of money—by selling their shares for more than they paid for them. For example, a strike price of an option was $5 a share. If the stock rose to $10 a share on the date the executive was permitted to actually make the purchase, he or she could turn around and sell the stock and realize an immediate profit of $5 a share. Multiply that by a million shares, and you’re talking real money. The option is “in the money” if executives can sell their shares for more than the strike price; it’s “underwater,” if they stand to lose money on the sale.

So, is giving incentive stock options to top executives a good idea?

The Pros:

ISOs are good for stockholders. An executive’s main responsibility is to increase the value of the company for its owners, namely the shareholders. When executives personally benefit when the stock value increases, they are likely to work harder and do a better job.

ISOs are good for companies. Offering incentive stock options helps companies attract and keep entrepreneurial executives who aren’t afraid to take the risks you need to take to grow. Stock options are a particularly good deal for promising start-up companies that are strapped for cash.

Incentive stock options are good for the executives. Not only do they have a chance to strike it rich if they perform well, but the proceeds from ISOs are usually taxed at the lower capital gains rate, not the higher personal income rate.

The Cons:

ISOs don’t really make the interests of executives the same as those of the stockholders. That’s because of the perfectly legal practice of repricing. If an executive’s option threatens to go underwater, the company can cancel the old options and reissue new ones at a lower strike price. “When the firm’s stock price does well, the people in charge make out like lottery winners,” writes John Cassidy in a 2002 New Yorker article. “When the stock price plummets, they get another set of chances to win.”

ISOs put undue pressure on managers. A good incentive plan ties a manager’s performance to factors that he or she has a reasonable chance of controlling. In reality, managers have little control over stock price. Although a company’s earnings record certainly does affect share price over the long run, so also do political events, rumors, crowd psychology, and even the weather.

CONS Continued:

ISOs provide incentives, all right, but it’s likely to be a perverse incentive. When executives can’t improve a firm’s performance, they work very hard at making their company’s performance look better than it actually is. Intent on propping up stock prices, they sometimes do this in legal ways, such as having the company repurchase its own stock, thus reducing the total number of shares. After all, earnings per share automatically improve if you divide profits by a smaller number. In addition, executives sometimes resort to illegal methods, such as when companies such as Enron and WorldCom issued fraudulent financial statements.

You Decide

Do you think ISOs are on the whole a good idea, though perhaps in need of some reforms? Or do you agree with Paul Volcker, that they need to be scrapped? Explain your answer.

An executive’s chief obligation is to the stockholder, and his or her main task is to increase stock value. Do you agree or disagree? Explain.

Some companies offer rank-and-file employees “nonqualified” stock options. The proceeds that result from exercising the option are taxed at the higher personal income rate—in other words, these options don’t qualify for the special tax advantages that ISOs do. And they are never repriced. Does this seem fair to you? Does it raise any ethical issues? Explain your answer.

Answer 1

Do you think ISOs are on the whole a good idea, though perhaps in need of some reforms? Or do you agree with Paul Volcker, that they need to be scrapped? Explain your answer.?
?Ans: ISOs are a good idea in principle since they are a means of tying the executive's pay with the performance of the company. since the company's performance correlates well with the performance of its stock on the stock market, ISO seem to be justifiable from the point of view of the market fundamentals.
?However, stock performance is not defined purely by the company's performance. They are affected by a number of unpredictable factors like crowd opinion, weather, market mood, opinions, state of the economy, geo-political factors, wars, famines etc. and thus are not in the control of the executives. Thus, to link a significant portion of the pay of the executive on some index that is controlled by factors over which the executive has no control does not seem like a sound idea.
?Secondly, companies follow the practice of repricing options when the share prices fall below the strike price to benefit the top executives. This seems like an unethical practice. This makes sense only when it can be proved beyond reasonable doubt that the fall in companies share price was due to factors beyond the control of the executive. But in cases where this is not true, it is a case of bending the rules for your own benefit.

?Part B
An executive’s chief obligation is to the stockholder, and his or her main task is to increase stock value. Do you agree or disagree? Explain.
Answer:
Agree and Disagree.. An executive is appointed by the Board of Governers who are in turn appointed in the annual General Body Meetinng of the company by the shareholders of the company. The compay's Articles of Association (AoA) and Memorandum of Understanding (MoA) define the nature of business, activities and agenda that the company must engage itself in.
Thus it can be safely said that the executive is accountable to the shareholders. But the second point which says that the executive's main task is to increase shareholder value may not be true in all cases. There might be additional tasks in the AoA that are not profit seeking and aim to give back to the society ( for example: sustainability and green initiatives). In some cases, the comany itself may be a not for profit or zer profit venture. In such cases, profit maximizing cannot be the sole objective.

?Part C
Some companies offer rank-and-file employees “nonqualified” stock options. The proceeds that result from exercising the option are taxed at the higher personal income rate—in other words, these options don’t qualify for the special tax advantages that ISOs do. And they are never repriced. Does this seem fair to you? Does it raise any ethical issues? Explain your answer.

Answer:
?This system does not seem fair. The primary objective of a tax system is to tax citizens at a rate that is commensurate with their income. this is so since the higher the income, the more-likely is the contribution of multiple individuals anf public resources for that income. For example, a company making million's of dollars mining iron ore does so by using public resources. Even when it pays the mining lcenses, the license fee does not take into account the externalities caused by the mine.
?Coming back to the point, since higher earning indivduals need to be taxed higher. In the case of ICOs and non qualified stock options, the nature of income is same (stock options linked to the company's performance), the only difference being the designation of the individuals who claim the tax advantage. Either the executives ICO's must be taxed at the personal income tax rate (highest slab) or the non qualifies stock options should be taxed at the ICO's tax rate to bring about a sytstem of equity.


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