Pyramid Electronics Essay

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Corporate Financial Policy – case assignment “Pyramid Electronics” 1. How much is the option compensation package of 15,000 options worth for a mid-level manager (assuming current stock price of $21, strike price of $24 and time to maturity of 5 years)? Annual risk-free rate can be taken from Exhibit 6 for 5yr period and is equal to 0.81%. The only missing variable to calculate the value of stock options using B-S model is the volatility. Since we do not have the data for historical volatility and estimating an average from the graph would not be particularly reliable, we can use the long-term (2+ year) call option prices provided in Exhibit 5 to reverse-engineer the volatility. Call option price Period until expiry Strike price Risk-free rate (approximation) Volatility (reverse-calculated using B-S model) 5.04 2 years, 1 month 18 0.27% 29.4% 1.52 2 years, 1 month 25 0.27% 23.4% 1.02 2 years, 1 month 27 0.27% 22.8% Average volatility 25.2% In order to improve accuracy we have taken an average of the three figures which is 25.2%. This is the annualized volatility for the period of just over 2 years. Since we do not have any other information, this will be our best estimate for the annualized volatility over 5 years. Using Black-Scholes calculator, we then get the call option price Ct = $3.93. As a result, the overall value of the compensation package of 15,000 options is about $58,907 (3.93*15000). 2. We employed Black-Scholes formula to calculate the value of the ESOs which is a rough estimate. Let us look at the following factors that make B-S method less suitable for ESOs than for regular options: 2.1 Listed options are generally shorter than ESOs so there aren’t any market price reference points. This leads to assumptions being made about volatility over fairly long periods of time in the future. For instance, in our calculations above we used the

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