Harmer Inc. is now a successful company. In the early days (before it became profitable), it issued
Question:
Harmer Inc. is now a successful company. In the early days (before it became profitable), it issued incentive stock options (ISOs) to its employees. Now Harmer is trying to decide whether to issue nonqualified options (NQOs) or ISOs to its employees. Initially, Harmer would like to give each employee 20 options (each option allows employees to purchase one share of Harmer stock). For purposes of this problem, assume that the options are exercised in three years (three years from now) and that the underlying stock is sold in five years (five years from now). Also assume the following facts:
- The after-tax discount rate for both Harmer, Inc. and its employees is 10 percent.
- Corporate tax rate is 21 percent.
- Personal (employee) ordinary income rate is 37 percent.
- Personal (employee) capital gains rate is 20percent.
- Exercise price of the options is $7.
- Market price of Harmer at date of grant is $5.
- Market price of Harmer at date of exercise is $25.
- Market price of Harmer at date of sale is $35.
Answer the following questions:
a. Considering these facts, which type of option plan, nonqualified (NQO) or incentive (ISO), should Harmer Inc. prefer? Explain?
b. Assuming Harmer issues NQOs, what is Harmer’s tax benefit from the options for each employee in the year each employee exercises the NQOs?
c. Assuming Harmer issues ISOs, what is the tax benefit to Harmer in the year the ISOs are exercised?
d. Which type of option plan should Harmer’s employees prefer?
e. What is the present value of each employee’s after-tax cash flows from year 1 through year 5 if the employees receive ISOs?
f. What is the present value of each employee’s after-tax cash flows from year 1 through year 5 if the employees receive NQOs?
g. How many NQOs would Harmer have to grant to keep its employees indifferent between NQOs and 20 ISOs?
Discount RateDepending upon the context, the discount rate has two different definitions and usages. First, the discount rate refers to the interest rate charged to the commercial banks and other financial institutions for the loans they take from the Federal...
Step by Step Answer:
Taxation Of Individuals And Business Entities 2019 Edition
ISBN: 9781259918391
10th Edition
Authors: Brian C. Spilker, Benjamin C. Ayers, John Robinson, Edmund Outslay, Ronald G. Worsham, John A. Barrick, Connie Weaver