Financial Challenges

Chapter 17
Repricing “Underwater Options”

Options are financial instruments that give the holder the right to buy or sell something in the future at a price established today. Call options give the holder the right (but not the obligation) to buy something, such as a share, in the future at a price (called the exercise or strike price) established today. Corporations frequently use stock options as part of their compensation plan to provide a strong incentive for the firm’s managers and employees to work hard to increase the value of the firm’s shares. If the combined actions of managers increase shareholder wealth, this will be reflected in increased share prices. Since the value of a call option at the time of exercise is equal to the difference between the share price and the exercise price, the holders of these options also benefit from the share price increase.

Stock options are used widely by corporations, both large and small, to provide a supplemental form of compensation to employees that more closely aligns the interests of managers with the interests of owners. Stock options, as incentives to managers, are a centrepiece of the economic value added (EVA) incentive systems proposed by Stern Stewart and discussed in Chapter 3.

Although there is growing evidence that the proper use of stock option plans can result in improved company performance, these compensation systems are not without problems. For example, consider the dilemma faced by the board of directors of Nortel in 2001. In the face of a slumping stock market, Nortel’s share price had dropped from a high of over $109 in July 2000 to less than $10 in 2001. Employees of the company held options to purchase more than 93 million Nortel shares. With the exercise price of these options so far above the share price, the board of directors was concerned that these options no longer provided the incentives needed for high future performance.

Accordingly, the board approved a new stock option program that terminated the old options and substituted new options at more realistic exercise prices. Unfortunately, Nortel’s share price continued to drop, so these new options are also underwater.

Nortel has not been alone in repricing the options it has granted to directors, managers, and employees. In recent years, almost all of the high-flying high-tech companies have repriced employee stock options to give them exercise prices much closer to the market share prices. Firms that have repriced their executive stock options argue that it is necessary in order to keep key employees. In addition, when an option is “deep out of the money,” much of the positive incentive for improved performance is lost.

The ultimate value of executive stock options in improving corporate performance is still the subject of debate. As you might guess, the policy of repricing options after a company’s share price has “tanked” is even more controversial.

In this chapter, we discuss the use of derivative financial instruments, including put and call options, their valuation, and their role in the financing plans of a company.

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