Question

Case 15-6 Effects of stock options

On January 1, 2016, as an incentive to improved performance of duties, Recycling Corp adopted a qualified stock option plan to grant corporate executives nontransferable stock options to 500,000 shares of its unissued $1 par value common stock. The options were granted on May 1, 2016, at $25 per share, the market price on that date. All the options were exercisable one year later and four years thereafter, providing that grantee was employed by the corporation at the date of exercise.

The market price of this stock was $40 per share on May 1, 2017. All options were exercised before December 31, 2017, at times when the market price varied between $40 and $50 per share.

Required:

a. What information on this option plan should be presented in the financial statements of Recycling Corporation at i)December 31, 2016 and ii)December 31, 2017? Explain.

b. It has been said that the exercise of such a stock option would dilute the equity of existing stockholders in the corporation.

i. How could this happen? Discuss.

ii. What conditions could prevent a dilution of existing equities from taking place in this transaction? Discuss.

Answer 1

A. i. As on Dec 31, 2016, the options are not exercised and they remain as options. They will not be reflected in the equity (liability side) of the fiinancial statements.

A.ii. Since the options have been exercised in May 2017, the options will get converted to shares and reflect n the equity (liability side) of the fiinancial statements.

B. Yes exercise of options will lead to dilution for the other investors as their stake % will decrease when more shares are issued on conversion of the options. The total number of shares of the company will increase and hence the stake % of each of the shareholder will decrease or in other words their stake will be diluted.

C. The non exercise of options can prevent dilution in this scenario. Non conversion will happen if the share price or the market price is below 25$ and remains below that level. Under such scenario, the option holders will have no incentive to convert their options into stock as the stock is available in the market at price below their exercise price of $25. This will prevent dilution of existing shareholders