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Q: Stock Options and NPV Question ( Answered ,   0 Comments )
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 Subject: Stock Options and NPV Question Category: Business and Money > Finance Asked by: bluesteel101-ga List Price: \$27.50 Posted: 18 Apr 2005 14:48 PDT Expires: 18 May 2005 14:48 PDT Question ID: 511002
 ```My parents currently own a nonqualified option to purchase 10,000 shares of a traded stock for \$11.75 per share. The option is about to expire, and the current market price of the stock is \$20. They are considering doing one of the following: 1) Exercise the option, then immediately sell enough shares to generate the cash necessary to pay their income tax on the bargain element and hold the remaining shares as an investment, or 2) Use other funds to pay the income tax and hold all 10,000 shares for investment. Either way, they intend to hold the investment shares for three years before selling them for cash. Their tax rate is 35%, and the stock will be their only investment asset. If there is a gain, they can use a 15% rate to compute the tax cost. If there is a loss, they can deduct the loss at only \$3000 a year. Also, their discount rate is 7%. My question revolves around NPV; what is their NPV under both alternatives if the stock goes up to \$30 dollars in three years? What is their NPV if the stock is only \$15 dollars in three years?``` Request for Question Clarification by omnivorous-ga on 19 Apr 2005 09:03 PDT ```Bluesteel101 ? I'd started to answer this question but the tax scenario makes it too complicated. There are 4 scenarios based on when taxes get paid -- as you can be taxed upon exercise of the options or at sale of the stock. I was going to simplify this to just the case of tax-deferred options but a careful reading of your question makes it sound as if your parents have taxable or "non-statutory" options. This can happen, even for company employees, if they're no longer employees at the time of the option. TAXES ======= This is the toughest part of the assumption because we don?t know if your options are non-statutory (taxes due upon exercise) or statutory (taxes due upon sale). Nor can we figure alternate minimum tax or excise tax treatments. But you can consult the following publication for details. Note this key section on statutory options, options for which taxes are deferred until the sale of the stock: ?There are two kinds of statutory stock options: * Incentive stock options (ISOs), and * Options granted under employee stock purchase plans.? U.S. Internal Revenue Service Publication 525 ? Taxable and Non-Taxable Income (2004) http://www.irs.gov/publications/p525/ar02.html#d0e2699 Please let me know if these options are taxable upon excercise, as there are already 4 scenarios in that case -- and 4 more if they're tax-deferred. Best regards, Omnivorous-GA``` Clarification of Question by bluesteel101-ga on 19 Apr 2005 12:27 PDT ```Omnivorous - Thanks for helping out - to clarify, the options are taxable upon sale; another words tax-deferred. Thanks!```
 ```Bluesteel101 ? Thank you for the clarification ? it makes things easier. There really are only four basic scenarios under which you borrow to capitalize the deal and sell at \$15 or \$30; sell shares today for funds and sell the balance at \$15 and \$30. Because the option puts the purchase price at \$11.75 there are no scenarios under which they lose money. Even \$15 a share is a gain. NPV CALCULATIONS =================== We?ve set up a spreadsheet in Microsoft Excel that analyzes the cash flows. The 7% discount rate is reasonable, given that Fannie Mae (mortgage) rates are about 5.6% this morning. We?ll use the same discount rate for the NPV as we do for the borrowings to buy the stock. The attached spreadsheet is viewable in most browsers and you can save it to your hard disk to make changes in the assumptions in the model. The following URL is case-sensitive: http://www.mooneyevents.com/OPTIONS.XLS PURCHASE SCENARIO =================== How many shares will it take to purchase the stock and pay the 15% taxes? It turns out that it?s 6,263 in whole shares. The gain (see B16 in the spreadsheet) is \$8.25 per share and current year?s taxes are \$7,750 at 15%. Those taxes may be due in a quarterly payment, so for timing sake we?ve put them in ?year 0,? the conventional way of saying ?today.? The balance of the shares ? 3,737 of them ? get sold in year 3 and the tax impact should be straightforward. BORROW SCENARIO ================== In borrowing for the purchase, no money goes out in the first year other than interest costs of \$8,225 on \$117,500 borrowed. We?ve placed them all at year-end (Year 1) because that?s when a tax credit will come back to reduce your parents overall taxes by \$2,879. In effect, the out-of-pocket interest expense is really only out \$5,346 each year due to tax reductions. But it?s important to remember that in Year 3 the proceeds get reduced by \$117,500 to pay back the principal. ANALYSIS ========= It?s no surprise that the best NPVs are at \$30, with borrowing returning an NPV of \$112,598 and selling an NPV of \$83,174. The value of that \$11.75 option goes to \$30 ? a growth rate of about 50% per year that is dramatically faster than the 7% discount rate. So it would be expected that owning more of it would more than offset borrowing costs. The second-best scenario is buying the stock if it goes to \$30, producing an NPV of \$83,174. But why is the borrowing case so bad if the stock?s only at \$15? Well, a growth of \$11.75 to \$15 is only about 9% per year ? and you?re paying 7% per year (before taxes) for the cost of money. Plus, you?re facing the tax obligation on the full 10,000 share gain ? where the purchase scenario has liquidated 62.63% of its tax obligation at purchase. OTHER OPTIONS =============== Yes, the pun is intended: guaranteeing a sales price of \$20 in 3 years is worth examining using a hedging strategy. That?s outside the scope of this question but a simple example would be purchasing Put options to cover the shares being held as ?insurance? that your returns on the shares are near \$20 ? and giving you almost all of the upside potential if shares to go \$30. Google search strategy: Exercising stock options IRS taxes Best regards, Omnivorous-GA```
 bluesteel101-ga rated this answer: `Outstanding support! Thanks!`