Eli Lilly and Company produces pharmaceutical products for humans and animals. Exhibit 7.18 includes a footnote excerpt from the annual report of Lilly for the period ending December 31, 2004.
Exhibit 7.18
Eli Lilly and Company
Stock Option Disclosures
Note-Stock-Based Compensation (partial footnote disclosure)
We adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS 123R), effective January 1, 2004. SFAS 123R requires the recognition of the fair value of stock-based compensation in net income. Stock options are granted to employees at exercise prices equal to the fair market value of our stock at the dates of grant. Generally, options fully vest three years from the grant date and have a term of 10 years.
We recognize the stock-based compensation expense over the requisite service period of the individual grantees, which generally equals the vesting period.
We recognized compensation cost in the amount of $108.2 million and $25.2 million in the first quarter of 2004 and 2003, respectively, as well as related tax benefits of $32.8 million and $8.8 million, respectively. Beginning with the 2004 stock option grant, we utilized a lattice-based option valuation model for estimating the fair value of the stock options. The lattice model allows the use of a range of assumptions related to volatility, risk-free interest rate, and employee exercise behavior. Expected volatilities utilized in the lattice model are based on implied volatilities from traded options on our stock, historical volatility of our stock price, and other factors. Similarly, the dividend yield is based on historical experience and our estimate of future dividend yields. The risk-free interest rate is derived from the U.S. Treasury yield curve in effect at the time of grant. The model incorporates exercise and post-vesting forfeiture assumptions based on an analysis of historical data. The expected life of the 2004 grants is derived from the output of the lattice model.
The weighted-average fair values of the options granted in the first quarter of 2004 were $16.06 per option, determined using the following assumptions:
Dividend Yield ........................................... 2.0%
Weighted-Average Volatility .......................... 27.8%
Range of Volatilities ........................... 27.6%-30.7%
Risk-Free Interest Rate ........................... 2.5%-4.5%
Weighted-Average Expected Life ................. 7.2 years
As of March 31, 2004, the total remaining unrecognized compensation cost related to non-vested stock options amounted to $397.5 million which will be amortized over the weighted-average remaining requisite service period of 2 years.
Source: Elli Lilly and Company, Form 10-K for the Fiscal Year Ended December 31, 2004.
Required
Review Exhibit 7.18 and answer the following questions.
a. Lilly's statement of cash flows (not provided in this problem) includes an add back for stock based compensation in calculating cash flows from operations of $108.2 million for 2004 and $25.2 million for 2003. Why does Lilly add stock-based compensation back to net income?
b. Refer to Requirement a. Lilly's statement of cash flows includes a cash inflow in the section on cash flows from financing activities of $12.5 million for 2004 and $46.5 million for 2003. The amounts are labeled ''Issuance of common stock under stock plans.'' Who provided these cash inflows to Lilly? In general terms, how are the amounts determined?
c. Lilly states in the note: ''Stock options are granted to employees at exercise prices equal to the fair market value of our stock at the dates of grant.'' Discuss why Lilly structured the stock option grants this way.
d. The note reports $397.5 million of remaining unrecognized compensation cost related to non-vested stock options. What portion of this amount will be reported as compensation expense in the second quarter ending June 30, 2004? Does this amount represent total stock-based compensation expense for the quarter?
e. In the past, firms were required to report pro forma earnings per share, taking into consideration stock-based compensation. Current financial reporting requires stock-based compensation to be reported in the income statement, and thus included in the calculations of reported earnings per share. Many firms also present non-GAAP earnings numbers before deducting the effects of stock compensation as a supplemental disclosure in their annual reports (which is comparable to the reported earnings number under the older rules). Why do companies do this? Which earnings number is more meaningful, net income or this non-GAAP measure?