Each tranche has the same exercise price— the market price of the stock on the grant date, or $ 23...

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Each tranche has the same exercise price— the market price of the stock on the grant date, or $ 23 on January 1, 2010. Explain why the option fair value increases with the vesting date. Management 120B Page | 2 2. Consider only the first option tranche vesting on December 31, 2010, and suppose that the price of Starbucks’ common stock is $ 40 on that date. Determine the compensation expense that Starbucks would record in 2010 for this first option tranche. No stock options are exercised by employees that year. 3. Suppose that the price of Starbucks’ common stock falls to $ 35 as of December 31, 2011. Considering only the first two option tranches, determine the compensation expense that Starbucks would record in 2011. No stock options are exercised by employees that year. 4. At the beginning of 2012, employees exercise 10,000 of the 2010 options. Employees hand over the 10,000 options along with $ 23 per option— the exercise price— and receive from the company an equal number of shares. The price of Starbucks’ common stock is $ 35 per share on the exercise date. Prepare the journal entry Starbucks will use to record this transaction. 5. In 2009, Starbucks’ shareholders approved a management proposal to allow for a onetime stock option exchange program, designed to provide employees an opportunity to exchange certain outstanding but underwater stock options for a lesser amount of new options granted with lower exercise prices. Under this proposal, employees could exchange options granted with an exercise price greater than $ 19 and receive new options with an exercise price of about $ 15. A total of 14.3 million stock options were tendered by employees and 4.7 million of new stock options were granted. According to the company’s financial statement note: “No incremental stock option expense was recognized for the exchange because the fair value of the new options, using standard employee stock option valuation techniques, was approximately equal to the fair value of the surrendered options they replaced.” Explain why a company might offer employees the opportunity to exchange underwater stock options for new options with a lower exercise price? 6. Explain how management determined that only 4.7 million of new options would be granted in exchange for the 14.3 million options tendered. In other words, why might management be reluctant to grant 10.0 million of the new options?

Robert · Accepted Answer

Question 1 
Fair value of the option has two components i.e. the intrinsic value and the time value. 
Intrinsic value can be defined as the value that can be derived from exercising the option 
today. The intrinsic value is not negative, and is always greater than zero. As the vesting 
period increases, number of options that can be exercised also increases, thus making it more 
favourable. In addition as per the Black-Scholes Model, lower expiration period yields higher 
fair value. So as the vesting date increases, fair value of the option goes up. 
Question 2 
Market price as on December 31, 2010 is $40 
Compensation expense = Number of Shares vested as on 31
st
 Dec 2010 * Market price per 
share = 25,000 * $40 = $10,00,000 
Since the stock option is not exercised, the following journal entry will be passed: 
Compensation expense   10,00,000 
 Paid-in capital(stock option)  10,00,000 
Question 3 
Market price of the stock falls to $35 on Dec 31, 2011 
Total shares vested till date = 50,000 
Total expense = 50,000 * $35 = 17,50,000 
Stock compensation expense recognized previously: 10,00,000 
Stock compensation to be recognized this year = 17,50,000 – 10,00,000 = 7,50,000 
Journal entry which will be passed: 
Compensation expense   7,50,

Each tranche has the same exercise price— the market price of the stock on the grant date, or $ 23 on January 1, 2010. Explain why the option fair value increases with the vesting date. Management...

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