Exhibit 7.19 summarizes the information disclosed by a large conglomerate regarding its stock option plans for Years 2-4. Assume an income tax rate of 35%.
Required
a. The average option price per share and market price per share at time of grant is equal in each year ($27.37 for Year 2, $31.19 for Year 3, and $32.26 for Year 4). Speculate on why the company structured the stock option grants this way in each year.
b. What are the likely reasons that the fair value of options granted per share increased from Year 2 to Year 3?
c. Compute the amount that the company received from the exercise of stock options each year versus the amount it would have received if it had issued the same number of shares on the market.
d. Refer to your answer to Requirement c. Discuss why the company is willing to sell shares of its stock to employees at a price (average option exercise price) much lower than the firm could obtain for shares sold on the market (average market price at time of exercise)?

e. Refer again to your answer to Requirement c. Compute the effect of stock-based compensation on net income for each year, assuming that stock option compensation expense equaled the difference between the market price and the exercise price of options exercised.
f. Discuss the strengths and weaknesses of each of the following approaches to recognizing the cost of stock options: (1) no expense as long as the option price equals the market price on the date stock options are granted, (2) expense in the year of the grant equal to value of options granted, and (3) expense in the year of exercise equal to the benefit realized by employees from purchasing shares for less than market value?

Exhibit 7.19 Stock Options Problem 7.22) Year 4 Year 3 Year 2 Number of options granted Average option price per share Average market price per share at time of grant Fair value of option granted per share Vesting period of options granted, years Option valuation assumptions: 27.141 32.26 32.26 $8.33 1-5 8.261 31.19 31.19 $ 9.44 1-5 46.928 $ 27.37 27.37 $ 7.73 1-5 Discount rate Volatility Dividend yield Expected option life, years 4.0% 27.7% 2.5% 6.0 43.110 10.54 32.68 3.596 34.7% 25% 6.0 43.829 $ 9.45 27.59 3.596 33.7% 2.7% 6.0 29.146 $ 9.45 31.86 Number of options exercised (in millions) Average option exercise price Average market price at time of exercise