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 |