Exhibit 9.21 includes a footnote excerpt from the annual report of the Coca-Cola Company for Year 4. The beverage company provides stock options offered to key employees under plans approved by stockholders.
Required
Review Exhibit 9.21 and answer the following questions:
a. Coke 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 Coke generates for the stock-based compensation provided to its employees? Speculate what income statement line item includes this tax savings, as well as what income statement line item including the stock-based compensation expense (income statement not provided in this problem)?
b. The average option price per share and market price per share at time of grant is equal in each year ($44.69 for Year 2, $49.67 for Year 3, and $41.63 for Year 4). Discuss why Coke structured the stock option grants this way in each year.
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. Coke 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 9.21 ($31.09 for Year 2, $26.96 for Year 3, and $35.54 for Year 4). Discuss why Coke 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. Coke employs the Black-Scholes valuation model for valuing stock option grants. Speculate on the directional effects of the key assumptions made in applying 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, and why?