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COMPARISON OF COMPENSATION COST RECOGNIZED UNDER FASB STATEMENT NO 123 AND APB OPINION NO 25 Assume the following for stock compensation awards made by Company A, a public company: Stock price at date of grant (January 1, 2000) Expected life of options Risk-free interest rate Expected volatility in stock price Expected dividend yield Vesting schedule for options Options expected to vest (5,000 forfeited each year) Estimated fair value of each option* Stock price at December 31, 2002 *Fair value calculated using an acceptable pricing model 285,000 $15 $60
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$40 6 years 70% 30% 15%
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100% at end of third year
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On January 1, 2000, Company A grants 300,000 stock options to of cers and other employees with a maximum term of 10 years and an exercise price equal to the market price of the stock at date of grant APB Opinion 25 Compensation cost recognized: Year 2000 Year 2001 Year 2002 Total $ $ $ 0 0 0 0 $1,425,000 1,425,000 $1,425,000 $4, 275, 000 FASB Statement No 123
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On January 1, 2000, Company A also grants 30,000 restricted shares to certain employees The restrictions lapse at the end of three years if certain annual earnings per share targets are met during the three-year period For purposes of this example, assume the earnings per share targets were met during the three-year period and the restrictions lapsed on December 31, 2002 APB Opinion 25 Compensation cost recognized Exhibit 397 $1,800,000 FASB Statement No 123 $1,200,000
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Comparison of Compensation Cost Recognized Under FASB Statement No 123 and APB Opinion No 25
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(d) OPTION PRICING MODELS In addressing the issue of estimating fair value of equity instruments, the FASB noted that it was not aware of any quoted market prices that would be appropriate for employee stock options Accordingly, FASB Statement No 123 requires that the fair value of a stock option (or its equivalent) be estimated using an option-pricing model, such as the Black-Scholes or a binomial pricing model, that considers the following assumptions or variables:
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Exercise price of the option Expected life of the option Considers the outcome of service-related conditions (ie, vesting
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requirements and forfeitures) and performance-related conditions Expected life is typically less than the contractual term Current price of the underlying stock Stock price at date of grant
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396 APPLICATION OF FASB STATEMENT NO 123
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39 41
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Expected volatility of the underlying stock An estimate of the future price uctuation of the
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underlying stock for a term commensurate with the expected life of the option Volatility is not required for nonpublic companies Expected dividend yield on the underlying stock Should re ect a reasonable expectation of dividend yield commensurate with the expected life of the option Risk-free interest rate during the expected term of the option The rate currently available for zero-coupon US government issues with a remaining term equal to the expected life of the options FASB Statement No 123 requires that the option pricing model utilized consider management s expectations relative to the life of the option, future dividends, and stock price volatility Both the volatility and dividend yield components should re ect reasonable expectations commensurate with the expected life of the option As there is likely to be a range of reasonable expectations about factors such as expected volatility, dividend yield, and lives of options, a company may use the low end of the range for expected volatility and expected option lives and the high end of the range for dividend yield (assuming that one point within the ranges is no better estimate than another) These estimates introduce signi cant judgments in determining the value of stock-based compensation awards During the FASB s discussions prior to issuance of FASB Statement No 123, those favoring retention of the basic requirements of APB Opinion No 25 emphasized the imprecision of measuring fair value through option pricing models, particularly in light of the fact that most stock options issued to employees are not transferable and are forfeitable The Board believes that it has addressed these issues by valuing at zero options that are expected to be forfeited, and by valuing options that vest based on the length of time they are expected to remain outstanding rather than on the stated term of the options During the last 20 years, a number of mathematical models for estimating the fair value of traded options have been developed The most commonly used methodologies for valuing options include the Black-Scholes model, binomial pricing models, and the minimum value method The minimum value of a stock option can be determined by a simple present value calculation which ignores the effect of expected volatility (See Exhibit 398 for an illustration of the minimum value method) The fair value of an option exceeds the minimum value because of the volatility component of an option s value, which represents the bene t of the option holder s right to participate in stock price increases without having to bear the risk of stock price decreases
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ESTIMATED OPTION VALUES Assumptions: Exercise price $40 (equals current price of underlying stock) Expected dividends 0%, 2%, and 4% Expected risk-free rate of return 7% Expected volatility 0%, 20%, 30%, and 40% Expected term six years Fair values calculated using a Black-Scholes option pricing model Volatility Dividend Rate 0% 2% 4% 0% $1335 887 496 20% $1514 1142 845 30% $1756 1398 1105 40% $2016 1657 1358
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