Valuing Employee Stock Options: (297 Wiley Finance)

A comprehensive guide to understanding the implications and applications of valuing employee stock options in light of the new FAS 123 requirements Due to the new requirements of the Proposed Statement of Financial Accounting Standards (FAS 123) released by the Financial Accounting Standards Board (FASB)-namely the fact that employee services received in exchange for equity instruments be recognized in financial statements-companies are now scrambling to learn how to value and expense employee stock options (ESOs). Based on author Dr. Johnathan Mun's consulting and advisory work with the FASB consulting projects with several Fortune 500 firms, Valuing Employee Stock Options provides readers with a comprehensive look at this complex issue. Filled with valuable information on binomial lattice and closed-form modeling techniques, Valuing Employee Stock Options can help financial professionals make informed decisions when attempting to ascertain the fair-market value of ESOs under the new requirements. Johnathan Mun, PhD, MBA, MS, CFC, FRM (San Francisco, CA), is Vice President of Analytical Services at Decisioneering, Inc., the makers of Crystal Ball analytical software. He is also the author of Applied Risk Analysis (0-471-47885-7), Real Options Analysis (0-471-25696-X), and Real Options Analysis Course (0-471-43001-3), all of which are published by Wiley.

Table of Contents:
List of Figures and Tables xi Preface xv Acknowledgments xvii About the Author xix PART ONE Impacts of the New FAS 123 Methodology CHAPTER 1 Implications of the New FAS 123 Requirements 3 A Brief Introduction 3 An Executive Summary of the FAS 123 Valuation Implications 5 Summary and Key Points 8 CHAPTER 2 The 2004 Proposed FAS 123 Requirements 11 FAS 123 Background 11 Summary and Key Points 17 CHAPTER 3 Impact on Valuation 19 A Brief Description of the Different Methodologies 19 Selection and Justification of the Preferred Method 19 Application of the Preferred Method 21 Technical Justification of Methodology Employed 22 Options with Vesting and Suboptimal Behavior 26 Options with Forfeiture Rates 28 Options Where Risk-Free Rate Changes over Time 29 Options Where Volatility Changes over Time 32 Options Where Dividend Yield Changes over Time 32 Options Where Blackout Periods Exist 35 Summary and Key Points 39 CHAPTER 4 Haircuts on Nonmarketability, Modified Black-Scholes with Expected Life, and Dilution 41 Nonmarketability Issues 41 Expected Life Analysis 45 Dilution 49 Summary and Key Points 49 CHAPTER 5 Applicability of Monte Carlo Simulation 51 Introduction to the Analysis 51 The Black-Scholes Model 52 Monte Carlo Path Simulation 52 Applying Monte Carlo Simulation to Obtain a Stock Options Value 53 Binomial Lattices 53 Analytical Comparison 54 Applying Monte Carlo Simulation for Statistical Confidence and Precision Control 54 Summary and Key Points 64 CHAPTER 6 Expense Attribution Schedule 65 ESO Expense Attribution Schedule as Minigrants 65 Summary and Key Points 73 PART TWO Technical Background of the Binomial Lattice and Black-Scholes Models CHAPTER 7 Brief Technical Background 77 Black-Scholes Model 77 Monte Carlo Simulation Model 79 Binomial Lattices 80 Summary and Key Points 81 CHAPTER 8 Binomial Lattices in Technical Detail 83 Options Valuation: Behind the Scenes 83 Binomial Lattices 87 The Look and Feel of Uncertainty 90 A Stock Option Provides Value in the Face of Uncertainty 92 Binomial Lattices as a Discrete Simulation of Uncertainty 94 Solving a Simple European Call Option Using Binomial Lattices 99 Granularity Leads to Precision 102 Solving American and European Options with Dividends 105 Customizing the Binomial Lattice 108 The Customized Binomial Lattice Model 109 Treatment of Forfeiture Rates 112 Summary and Key Points 115 Appendix 8A—Binomial, Trinomial, and Multinomial Lattices 115 CHAPTER 9 The Model Inputs 119 Stock and Strike Price 119 Time to Maturity 120 Risk-Free Rate 120 Dividend Yield 121 Volatility 121 Logarithmic Stock Price Returns Approach 121 Annualizing Volatility 123 GARCH Model 123 Market Proxy Approach 124 Implied Volatilities Approach 125 Vesting 125 Suboptimal Exercise Behavior Multiple 126 Forfeitures 127 Blackout Periods 128 Lattice Steps 128 Summary and Key Points 129 PART THREE A Sample Case Study Applying FAS 123 CHAPTER 10 A Sample Case Study 133 Stock Price and Strike Price 133 Maturity 135 Risk-Free Rates 136 Dividends 136 Volatility 136 Vesting 140 Suboptimal Exercise Behavior Multiple 141 Forfeiture Rate 145 Number of Steps 145 Results and Conclusions 147 Summary and Key Points 157 Appendix 10A—Introduction to the Software 158 Getting Started 158 ESO Toolkit 158 ESO Functions 161 Auditing Templates and Spreadsheets 164 PART FOUR Options Valuation Results Tables APPENDIX Getting Started with the Options Valuation Results Tables 169 Thirty-Five Percent Volatility and 3-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 171 Seventy Percent Volatility and 3-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 179 Thirty-Five Percent Volatility and 5-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 187 Seventy Percent Volatility and 5-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 199 Thirty-Five Percent Volatility and 7-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 211 Seventy Percent Volatility and 7-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 227 Thirty-Five Percent Volatility and 10-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 243 Seventy Percent Volatility and 10-Year Maturity ESOs with Varying Stock Price, Suboptimal Behavior, Vesting Period, and Forfeiture Rates 267 Glossary 291 Notes 295 About the CD-ROM 301 Index 305

About the Author :
JOHNATHAN MUN is Vice President of Analytical Services at Decisioneering, Inc., the makers of Crystal Ball® analytical software. His duties focus primarily on heading up the development of real options and financial analytics software powered by Crystal Ball. Prior to joining Decisioneering, he was a consulting manager and financial economist in the Valuation Services and Global Financial Services practice of KPMG Consulting, and a manager with the Economic Consulting Services practice at KPMG LLP. He holds a PhD in finance and economics, and an MBA and MS in management. Mun is also certified in financial risk management and in financial consulting. He is currently a visiting professor in finance, economics, and statistics at various universities, including the University of Applied Sciences (Germany), the Swiss School of Management (Switzerland), and Golden Gate University (California). Mun is the author of Applied Risk Analysis, Real Options Analysis, and Real Options Analysis Course, all published by Wiley. He continues to offer worldwide seminars and lectures on the topics of real options, simulation and risk analysis, and corporate finance.