Suppose you are a high-level employee of Drugstore.Com. You currently hold 50,000 NQOs, each with an exercise price of $20. The options vest—that is, you are no longer restricted from exercising them—in 1 month. Your current and expected future tax rate on ordinary income is 39.6% and on capital gains is 20%. The stock is currently trading at $35, and you expect the stock to appreciate at 20% per year over the remaining 7 years of the options’ life. You have an after-tax discount rate of 10%. Should you exercise the NQOs immediately on vesting and hold the stock, or hold the options through to maturity before exercising? Would your answer change if you held ISOs instead of NQOs?
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