7. OBJETIVOS
7.2 Objetivos específicos
This study seeks to determine whether employee stock options have characteristics of liabilities or of equity, which is an open research and financial reporting question. We focus our tests on how the options relate to firms’ common equity risk and expected return. Based on previously untested finance theory, we predict that because employee stock options are warrants issued and settled by the firm, employee stock options are associated with lower common equity
38
risk and expected return. Our evidence supports this prediction. In particular, we find that realized common equity return volatility, volatility implied by a firm’s traded options, and expected common equity cost of capital all are negatively associated with the extent to which firms have outstanding employee stock options. This suggests that options should not be treated as liabilities.
Consistent with the theory upon which our tests are based, we also find that the relation between employee stock options and the risk of common equity is significantly less negative for firms with options with longer terms to maturity and positive for firms that reprice options.
These findings indicate that the terms of employee stock options are important, and can negate the risk-reducing characteristics of options relative to traditional warrants.
We examine the relation between leverage and common equity risk for two accounting regimes—one that treats options as equity and one the treats options as debt. Consistent with our other findings, we find that leverage based on treating options as equity has a significantly
stronger positive relation with both of our measures of common equity risk than leverage based on treating options as debt. These findings indicate that classifying employees options as debt would undermine the representational faithfulness of leverage based on financial statement classification with respect to common equity risk.
Finally, we find that the sensitivity of the value of employee stock options to changes in asset value is similar to that of equity value and the opposite to that of debt value. In addition, our evidence shows that employee stock options have much higher risk and expected return than common equity; the expected return for options is approximately 70% larger than the expected return on common equity.
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Our findings contribute to the literature by establishing the empirical relation between employee stock options and common equity risk and expected return, with predictions based on warrant pricing theory, and, in doing so, empirically validating the predictions of warrant pricing theory. Our findings also contribute to the debate about what characteristics should distinguish liabilities and equity for financial reporting purposes. Our findings show that employee stock options de-lever common equity, rather than lever it. They also show that employee stock
options have higher risk and expected return than common equity claims against the same assets.
Thus, the findings suggest that these option claims are more residual than common equity claims and, as a result, that these options essentially form a second type of equity. Taken together, our findings are not consistent with classifying employee stock options as liabilities.
40 Appendix
This appendix offers a numerical example to illustrate the effects of employee stock option issuance on a firm’s capital structure and the accounting issues addressed in this study.
To facilitate comparison with Kirschenheiter et al. (2004), we begin with a simplified set of assumptions. In particular, we consider an all-equity firm created at the end of year zero by raising equity. Proceeds of $100.00 from the sale of 100 shares are invested in productive assets earning a certain after-tax return of 10%. All available cash flow is retained and invested. At the end of year one when the stock price is $1.10, the firm grants 47.14 at-the-money options in lieu of $9.00 of cash wages.38 The options are exercised at the end of year three. At the end of year four, the firm is liquidated.
Figure 1 shows financial statements and key performance measures for three
presentations of options. In the first panel, options are presented as liabilities. In the second panel, options are presented as equity claims against the expected value of assets, where the expected value of assets includes the present value of the strike price, and the value of the option equity claim equals the value of the option holders’ undivided interest in the firm’s assets.39 This presentation “grosses up” the statement of financial position by the strike price receivable and allows us to illustrate the valuation mechanics of options. The third panel shows the expected strike price receivable netted against the option equity. Panel 3 is most consistent with current GAAP.40
In each panel of Figure 1, the value of common equity at the end of each period equals the present value of the liquidation proceeds distributed to common equity holders at time T:
38 The number of options equals $9.00 divided by the price of a single option with a strike price of $1.10.
39 Option holders’ undivided interest equals 32% of firm assets and future income, 47.14/(100 + 47.14).
40 We ignore deferred taxes because they complicate the analysis without providing additional insight about liability/equity classification of option claims. Including deferred taxes does not alter the example’s conclusions.
41
(A1)
where n is the number of shares of common, m is the number of option shares, and MVAT is the value of assets when the assets are liquidated.41 Based on the assumed facts, common equity holders (option holders) expect to receive 68% (32%) of the liquidation value of assets in period four. The liquidation value of assets includes the cash received from option holders in period three plus cumulative reinvested earnings.
Figure 1 shows that the market value of assets is $161.85 after the options are issued at the end of period one, reflecting the expected strike price receivable. The book value of assets differs from the market value of assets in Panels 1 and 3 because the present value of the strike price is not included in assets under the options-as-liabilities approach or current GAAP. In contrast, when the present value of the strike price is included in assets, as shown in Panel 2, the book value of assets equals the market value of assets in each period. Under this approach, equity essentially reflects the value of stock subscribed.
When options are presented as liabilities, as in Panel 1, financial expense is imputed by multiplying the value of the option grant by the expected rate of return. This leads to lower net income that more accurately reflects the income attributable to existing common equity holders (Kirschenheiter et al. 2004). However, imputing option financial expense understates the reported return on assets (ROA), which is assumed by the example to be a constant 10%.
Moreover, leverage is positive when options are treated as liabilities, which overstates the default risk of this unlevered firm.
In contrast, when the option is presented in two parts as shown in Panel 2, financial income is imputed as the increase in the present value of the strike price. However, consistent
41The value of the option claims is determined similarly, except that the fraction of proceeds equals m/(n + m).
42
with current GAAP, increases in the market value of option equity would not be included in net income. Panel 2 shows that ROA is correctly reported at 10% and reported leverage is zero, consistent with the example firm’s fundamentals. Panel 3 reveals the same outcomes—ROA of 10% and reported leverage of zero.
Figure 1 shows that classifying options as liabilities overstates the firm’s reported
leverage and understates reported ROA while the options are outstanding. However, theory also predicts that option issuance decreases the risk of and expected return on common equity. These predictions cannot be illustrated under certainty because all cash flows earn the same risk-free rate of return (assumed to be 10% in the example). Therefore, we modify the example to include uncertainty, as shown in Figure 2. We maintain an expected after-tax return of 10% for the assets but set the standard deviation of equity returns equal to 44%.
For an all-equity firm, the return to, and variance of, equity equal the return to, and variance of, assets. However, the issuance of contingent claims changes the capital structure of the firm. We quantify the effects of capital structure changes by using a binomial pricing model to compute the expected values and expected rates of return of each equity component over the two-year term of the options.
Because uncertainty increases the value of options, the firm must issue only 38.78 options to compensate employees $9.00, rather than the 47.14 options that the firm must issue in the certainty case. This results in a total strike price of $42.66. In Figure 2, the terminal nodes of the binomial trees show expected values of for assets, equity, and options at the end of period three. For ease of exposition, the end of period three is assumed to be the option expiration date, and option value and asset value are presented both gross and net of the strike price.42
42 The $9.00 option price equals the $16.68 expected present value of the option holders’ claim on the firm’s gross assets, i.e., including the strike price, less the $7.68 expected present value of the $42.66 strike price.
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The asset price tree in the upper left-hand corner of Figure 2 shows the progression of asset values that occurs when employees are paid cash instead of options. This can be compared to the asset price tree immediately beneath it, which shows a higher expected terminal value ($143.99 compared to $133.10) when cash is conserved by paying compensation with options (with options, assets are $119.00 at the beginning of the term, rather than $110.00, because the firm has conserved $9.00 in cash that would have been paid in wages). Comparing asset trees in Figure 2 reveals that the 10% expected return on assets is invariant to the issuance of options.
The asset price tree in the lower left-hand corner also shows the effect of the strike price on the expected value of assets, which increases to $126.68 when the future expected cash flow arising from option exercise is included. Note that the $42.66 strike price is not included in the
calculation of the return of 10% because the strike price is a contribution of capital rather than income.
The option price tree in the bottom center of Figure 2 shows that if the options are exercised, option holders receive net value of $50.01 after payment of the strike price,
representing a total two-year return of 456% on their $9.00 investment. However, computing the options’ return based only on the exercise value is misleading because the options expire
worthless 75% of the time, in this example. The options’ expected gross terminal value of
$23.17 incorporates the potential that the options expire worthless; thus, the options’ expected return at the date of issuance is a more reasonable 18%. The value of the option holders’ gross claim on total assets is $16.68, which combines with the equity holders’ claim of $110.00 to equal the expected total asset value of $126.68.
The equity price tree in the bottom right-hand corner of Figure 2 reveals that the value of equity does not change when options are issued: the value of equity remains equal to the
pre-44
option-issuance value of $110.00. This is true even though the expected present value of assets increases. Comparing the 100% common equity firm in the upper right-had corner to the equity price tree with options immediately beneath it (the mixed equity firm) reveals that the mixed equity firm has a narrower range of potential terminal common equity values ($49.01 to $238.94 compared to $45.30 to $267.10). The variance is lower because the option holders’ $9.00 cash wage forfeiture provides insulation against downside outcomes, and because the options absorb a fraction of upside outcomes. Consistent with the lower variance, the expected return on common equity also is lower in the presence of options (9% compared to 10%).
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Figure 1: Three Presentations of Options
____________________________________________________________________________________________
Panel 1: Options as Liabilities
Panel 2: Options as Equity (Including Strike Price)
Panel 3: Options as Equity (Net of Strike Price)
1 2 3 4 1 2 3 4 1 2 3 4
Statement of Financial Position:
Operating Assets 119.00 130.90 195.84 215.43 119.00 130.90 195.84 215.43 119.00 130.90 195.84 215.43
Financial Assets 42.85 47.14
Total Assets 119.00 130.90 195.84 215.43 161.85 178.04 195.84 215.43 119.00 130.90 195.84 215.43
Stock Option Liability 9.00 9.90
Owner’s Equity—Options 51.85 51.85 9.00 9.00
Contributed Capital 100.00 100.00 162.74 162.74 100.00 100.00 151.85 151.85 100.00 100.00 160.85 160.85 Retained Earnings 10.00 21.00 33.10 52.68 10.00 26.19 43.99 63.57 10.00 21.90 34.99 54.57 Total Equity 110.00 121.00 194.84 215.43 161.85 178.04 195.84 215.43 119.00 130.90 195.84 215.43 Total Liabilities and Equity 119.00 130.90 195.84 215.43 161.85 178.04 195.84 215.43 119.00 130.90 195.84 215.43
Leverage (Debt/Assets) 8% 8% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%
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Figure 1: Three Presentations of Options (continued)
____________________________________________________________________________________________
Panel 1: Options as Liabilities
Panel 2: Options as Equity (Including Strike Price )
Panel 3: Options as Equity (Net of Strike Price)
1 2 3 4 1 2 3 4 1 2 3 4
Income Statement:
Operating Income (Before Option Expense)
19.00 11.90 13.09 19.58 19.00 11.90 13.09 19.58 19.00 11.90 13.09 19.58
Option Expense -9.00 -9.00 -9.00
Financial Income (Expense) -0.90 -0.99 4.29 4.71
Net Income 10.00 11.00 12.10 19.58 10.00 16.19 17.80 19.58 10.00 11.90 13.09 19.58
Market Values:
Option Claims (32%) 51.85 57.04 62.74 69.02 51.85 57.04 62.74 69.02 51.85 57.04 62.74 69.02 Common Claims (68%) 110.00 121.00 133.10 146.41 110.00 121.00 133.10 146.41 110.00 121.00 133.10 146.41 Assets 161.85 178.04 195.84 215.43 161.85 178.04 195.84 215.43 161.85 178.04 195.84 215.43
Market Return on Assets 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
Book Performance Measures:
Return on Assets (Net Income/Assets)
10% 9% 9% 10% 10% 10% 10% 10% 10% 10% 10% 10%
Return on Equity (Net Income/Equity)
10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
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Figure 2: Effect of Options on Expected Return
Figure 2: Effect of Options on Expected Return