Fifteen years ago, in fiscal year 2002, Microsoft granted 254,000,000 stock options to its employees as part of their compensation. The options had an expiration of 10 years and an exercise price of $24.27. Assume that Microsoft’s dividend rate was 0%, its stock volatility was 0.39, the risk-free rate was 5.4%, the price of Microsoft stock on the date of grant was $24.27, and the number of shares outstanding was 10,700,000,000.
1. What was the fair market value of all these 2002 executive stock options on their date of grant, according to the Black-Scholes formula?
2. Suppose that Microsoft had used a different compensation policy and decided to grant shares of stock to its employees instead of stock options. How many shares would the company have needed to issue to deliver the same amount of economic value as calculated in the answer to question 1 above? Assume the stock price is $24.27 per share.
3. If the stock’s volatility was 0.39, then Microsoft’s shares had a two-thirds probability of rising or falling by 39% or less over the next year. If the stock had risen 39% over the next year, what would have been the value of the options granted in question 1, and what would have been the value of the shares granted in question 2? If the stock had dropped 39% over the next year, what would have been the value of these shares and options? Assume that volatility, dividends, and the risk- free rate are unchanged.
4. Based on your answer to question 3, which would have been a better compensation policy for Microsoft: delivering an equal amount of economic value through shares or through options? In reaching your conclusion, what goals and assumptions would have seemed most important to you? Are you surprised that in the years since 2002, Microsoft and many other firms have shifted their equity compensation away from options and largely toward shares?