Reference no: EM13901946
STOCK-BASED COMPENSATION. Exhibit 6.16 includes a footnote excerpt from the annual report of The Coca-Cola Company for Year 4. The beverage com- pany offers stock options to key employees under plans approved by stockholders.
Required
Review Exhibit 6.16 and answer the following questions.
a. Coca-Cola reports both pretax and after-tax stock-based compensation in its notes to the financial statements. What is the tax savings for Year 2, Year 3, and Year 4 that Coca-Cola generates from the stock-based compensation provided to its employees? Speculate on what income statement line item includes this tax savings as well as what income statement line item includes the stock-based compensation expense. (The income statement is not provided in this problem.)
b. The average option price per share and market price per share at time of grant is equal each year ($44.69 for Year 2, $49.67 for Year 3, and $41.63 for Year 4). Discuss why Coca-Cola structured the stock option grants this way each year.
Our Company currently sponsors stock option plans. Effective January 1, Year 2, our Company adopted the prefer- able fair value recognition provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation." The fair values of the stock awards are determined using a single estimated expected life. The compensation expense is recognized on a straight-line basis over the vesting period. The total stock-based compensation expense, net of related tax effects, was $254 million in Year 4, $308 million in Year 3 and $267 million in Year 2.
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Exhibit 6.16
The Coca-Cola Company
Stock Option Discloures
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Year 4
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Year 3
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Year 2
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Stock-Based Compensation Expense, pretaxa
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$ 345
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$ 422
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$ 365
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Number of Options Grantedb
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31
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24
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29
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Average Option Price per Share
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$41.63
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$49.67
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$44.69
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Average Market Price per Share at Time of Grant
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$41.63
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$49.67
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$44.69
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Fair Value of Option Granted per Share
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$ 8.84
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$13.49
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$13.10
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Vesting Period of Options Granted, years
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1-4
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1-4
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1-4
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Life of Options, years
Option Valuation Assumptions for Black-Scholes Modelb
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10
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10
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10
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Risk-Free Interest Rate
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3.8%
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3.5%
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3.4%
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Dividend Yield
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2.5%
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1.9%
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1.7%
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Stock Volatility
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23.0%
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28.1%
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30.2%
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Expected Option Life, years
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6.0
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6.0
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6.0
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Number of Options Exerciseda
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5
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4
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3
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Average Option Exercise Price
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$35.54
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$26.96
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$31.09
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aAmounts in millions.
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bWeighted averages.
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c. What are the likely reasons that the fair value of options granted per share increased from Year 2 to Year 3 and then decreased from Year 3 to Year 4?
d. Coca-Cola does not report the market price of its stock at the time employees exercised options (3 million in Year 2, 4 million in Year 3, and 5 million in Year 4), but in each year the end-of-year market price is substantially higher than the average option exercise price reported in Exhibit 6.16 ($31.09 for Year 2, $26.96 for Year 3, and $35.54 for Year 4). Discuss why Coca-Cola is willing to sell shares of its stock to employees at a price (option exercise price) much lower than the firm could obtain for shares sold on the market (market price at time of exercise).
e. Coca-Cola employs the Black-Scholes valuation model for valuing stock option grants. Speculate on the directional effects of the key assumptions made in apply- ing the Black-Scholes options pricing model. That is, which assumptions will result in a higher fair value for stock options and which will result in a lower fair value? Why?