Question

Under its executive stock option plan, National Corporation granted 30 million options on January 1, 2018, that permit executives to purchase 30 million of the company’s $1 par common shares within the next six years, but not before December 31, 2020 (the vesting date). The exercise price is the market price of the shares on the date of grant, $30 per share. The fair value of the options, estimated by an appropriate option pricing model, is $3 per option. No forfeitures are anticipated.

1. Ignoring taxes, what is the total compensation cost pertaining to the stock options?
2. Ignoring taxes, what is the effect on earnings in the year after the options are granted to executives?

(For all requirements, enter your answer in millions (i.e., 10,000,000 should be entered as 10).)
  

1.) Total Compensation Cost = __________

2.) Effect on Earnings decreased by =_________

Answer 1

Vesting period = 1st Jan 2018 to 30th Dec 2020 i.e, 3 years

Exercise period = 6 years - 3 years = 3 years

Number of Options = 30 million

Exercise price= $30

Fair Value of Stock Option = $3

Intrinsic value = 0 , (Since, Exercise price = Market value of share)

Calculation of Compensation Cost= Number of options * Fair value of stock option

$30 million* $3

=$90 million

Yearly Distribution of compensation Cost over the vesting period = Total Compensation cost / vesting period

= ($90 million/ 3 years) = $30 million

Hence, the  earnings in the year after the options are granted to executives, is reduced by $30 million.