Are Employee Stock Options Liabilities or Equity?

Transcription

1 Are Employee Sock Opions Liabiliies or Equiy? Mary E. Barh Sanford Universiy Leslie D. Hodder Indiana Universiy Sephen R. Subben The Universiy of Norh Carolina a Chapel Hill [email protected] Ocober 2011 We wish o hank Parick Hopkins, Jim Wahlen, Michael Kirschenheier, Sephen Penman, and workshop paricipans a The Wharon School of he Universiy of Pennsylvania, Florida Inernaional Universiy, Harvard Universiy, Oklahoma Universiy, Singapore Managemen Universiy, and Brigham Young Universiy for helpful discussions and commens. Leslie Hodder graefully acknowledges financial suppor from Erns and Young, LLC.

2 Are Employee Sock Opions Liabiliies or Equiy? Absrac This sudy seeks o deermine wheher employee sock opions have characerisics of liabiliies or equiy, which is an open financial reporing quesion. As prediced, we find ha common equiy risk and expeced reurn are negaively associaed wih he exen o which a firm has ousanding employee sock opions, which is inconsisen wih he opions having characerisics of liabiliies. We also find ha he associaion is less negaive for firms ha reprice opions and firms ha have longer-erm opions, which indicaes ha some employee sock opions have characerisics ha make hem more similar o deb. In addiion, we find ha he sensiiviy of employee sock opion value o changes in asse value mirrors ha of common equiy value and is opposie o ha of deb value. The evidence also reveals ha, unlike liabiliies, employee sock opions have subsanially higher risk and expeced reurn han common equiy. Our findings are no consisen wih classifying employee sock opions as liabiliies for financial reporing purposes; raher, he opions ac as a second ype of equiy. Our analyses and findings sugges a classificaion scheme for claims agains he firm namely, classify as liabiliies (equiy) claims ha increase (decrease) common equiy risk and expeced reurn.

3 Are Employee Sock Opions Liabiliies or Equiy? I. INTRODUCTION We address wheher employee sock opions have characerisics of liabiliies or of equiy. In paricular, we seek o undersand he relaion beween employee sock opions and he risk of and expeced reurn on common equiy. This undersanding is imporan in assessing he role of employee sock opions in he capial srucure of he firm, and is relevan o he debae abou wheher employee sock opions should be classified as liabiliies or equiy for financial reporing purposes. Our ess focus on he signs of he associaions beween he risk of and expeced reurn on he firm s common equiy and he exen o which a firm has ousanding employee sock opions. Finance heory predics ha leverage increases he risk of and expeced reurn on common equiy. Thus, if he associaions beween employee sock opions and common equiy risk and reurn are posiive, we infer ha employee sock opions have characerisics of liabiliies. If he associaions are negaive, we infer he opposie. We find ha he exen o which a firm has ousanding employee sock opions is significanly negaively relaed o boh common equiy risk and he expeced reurn on common equiy, which is inconsisen wih employee sock opions having characerisics of liabiliies. Our sudy is relevan o he curren financial reporing debae abou wha characerisics should disinguish liabiliies and equiy for financial reporing purposes. Thus far, he Financial Accouning Sandards Board (FASB) and he Inernaional Accouning Sandards Board (IASB) have been unable o develop a clear principle ha disinguishes liabiliies from equiy for financial reporing. There is no debae abou wheher exising common sock should be classified as equiy and sraigh deb should be classified as liabiliies. However, equiy for financial reporing need no be limied o exising common equiy. The debae is abou wheher 1

4 financial insrumens embodying oher ypes of claims agains he firm s asses should be classified as oher ypes of equiy or as liabiliies and, if so, wha characerisics of hose insrumens are relevan o deermining he classificaion. The FASB s curren Concepual Framework defines equiy as he residual of asses minus liabiliies, where liabiliies are presen obligaions, he selemen of which requires a ransfer of he firm s asses. However, his characerizaion of liabiliies is subjec o criicism because deermining wheher a presen obligaion exiss is subjecive, and because he form of selemen is subjec o srucuring. For hese reasons, a growing body of lieraure and he FASB s Preliminary Views on how o accoun for financial insrumens wih characerisics of equiy advocae classifying all claims oher han common sock as liabiliies. This is referred o as he basic ownership approach because i would classify only basic ownership insrumens, i.e., common sock, as equiy and classify all oher claims as liabiliies. Under he basic ownership approach, mos preferred sock and coningen claims including employee sock opions would be classified as liabiliies, unless hey are specifically exemped from he approach. In par because of his, here has been resisance o adoping he basic ownership approach. We inform his debae by showing ha he relaion beween a financial claim and he risk of and expeced reurn on exising common equiy for which here is no financial reporing classificaion debae can be used o disinguish liabiliies from equiy. Our predicions and ess are based on warran pricing heory. Alhough he value of employee sock opions is commonly esimaed using opion pricing models, employee sock opions are warrans. For our sudy, a key difference beween warrans and opions is ha he wo ypes of insrumens differ wih respec o he eniy responsible for heir selemen. In paricular, whereas warrans are claims agains and seled by he firm, opions on a firm s shares 2

5 are claims agains oher eniies ha wroe opions on a firm s shares. Because warrans are issued and seled by he firm, he issuance of warrans e.g., employee sock opions should affec he risk of and expeced reurn on all exising equiy claims. Theory predics ha he issuance of warrans decreases he expeced risk of and reurn on he firm s common equiy, which is consisen wih employee sock opions de-levering he firm s common equiy, no levering i as do liabiliies. This is no rue of opions on he firm s shares wrien by oher eniies, which have no effec on he firm s capial srucure. Alhough finance heory oulines he implicaions of employee sock opions for common equiy risk and expeced reurn, empirical ess of hese implicaions are absen from he lieraure. We fill his void by esing he relaions beween common equiy risk and expeced reurn and he exen o which he firm has employee sock opions ousanding. Firs, we es wheher common equiy risk is posiively or negaively associaed wih he exen o which a firm has employee opions ousanding. We use wo measures of common equiy risk realized common equiy volailiy and common equiy volailiy implied by he prices of a firm s raded opions. Following prior research, our ess include conrols for leverage, credi risk, firm size, earnings, change in earnings, and analys forecass of earnings growh. In addiion, because riskier firms migh issue more opions and because opions can provide incenives for riskaking, we also include conrols for a firm s propensiy o issue opions and for subsequen risky invesmen. Second, we es wheher he expeced reurn on common equiy is posiively or negaively associaed wih he exen o which a firm has employee opions ousanding. Our measure of expeced reurn is an esimae of expeced cos of capial based on he Fama-French and momenum facors. Following prior lieraure, our expeced reurn ess include conrols for 3

6 leverage, firm size, equiy book-o-marke raio, bea, momenum, analys forecass of earnings growh, and dispersion in analys forecass. We find ha common equiy risk is significanly negaively associaed wih he exen o which he firm has ousanding employee sock opions, using boh measures of equiy risk. Also consisen wih finance heory, we find ha he relaion beween employee sock opions and he risk of common equiy is significanly less negaive for firms wih longer opion erms and for firms ha reprice opions. These findings indicae ha opions wih hese aribues affec common equiy more like deb han opions wihou hese aribues. For firms wih longer-erm opions, he relaion beween employee sock opions and common equiy risk is significanly negaive, which indicaes ha hese opions have characerisics of equiy and, hus, are only somewha more like deb han shorer-erm opions. However, for firms ha reprice opions, he relaion beween opions and common equiy risk is no negaive, which indicaes ha hese opions do no have characerisics of equiy. These findings reveal ha employee sock opions can have erms ha negae he equiy-like characerisics of warrans. We also find ha he expeced reurn on common equiy is significanly negaively associaed wih he exen o which he firm has ousanding employee sock opions. These findings suppor he predicions of finance heory and indicae ha employee sock opions delever a firm s common equiy, no lever i. Therefore, our findings sugges i would be inappropriae o classify employee sock opions as liabiliies for financial reporing purposes. We nex provide evidence on he sensiiviy o changes in he value of he firm s asses of he value of employee sock opions, he value of deb, and he value of common equiy. Finance heory predics ha deb and equiy values respond differenly o changes in asse value. In paricular, heory predics ha he elasiciy of deb value o changes in asse value is concave, 4

7 whereas ha of common equiy value is convex. Thus, as he value of a firm s asses exceeds he value of is deb by a larger margin, he sensiiviy of deb value o changes in asse value approaches zero and he sensiiviy of equiy value o changes in asse value approaches one. To assess he elasiciy of employee sock opion values, we use a recenly developed warran pricing model. Our empirical ess reveal ha he sensiiviy of employee sock opion values o changes in asse value is convex, similar o ha of common equiy value. In conras bu consisen wih heory, our empirical ess show ha he sensiiviy of liabiliy values o changes in asse value is concave. These findings confirm he inferences from our primary ess ha employee sock opions share he risk and reurn characerisics of common equiy, bu do no share hese characerisics of liabiliies. We use our esimaes of expeced common equiy reurn and parameer esimaes from he warran pricing model o esimae he expeced reurn on employee sock opions. We find ha he expeced reurn on opions averages approximaely 70% more han he expeced reurn on common equiy. These findings indicae ha employee sock opions are subsanially more risky han non-opion equiy, which also is inconsisen wih he opions sharing he characerisics of liabiliies. The remainder of he paper proceeds as follows. Secion II discusses he background for our inquiry and relaed research, and Secion III oulines our research design. Secion IV describes our daa and presens our findings relaing o equiy risk and expeced reurn. Secion V presens evidence on how he values of deb, employee sock opions, and non-opion equiy respond o changes in asse value, and esimaes of he expeced reurn on employee sock opions. Secion VI summarizes and concludes. 5

8 II. BACKGROUND AND RELATED RESEARCH Capial srucure effecs of employee sock opions Alhough he value of employee sock opions is commonly esimaed using opion pricing models, he erms of employee sock opions differ from hose of radiional opions as specified in hese models. Employee sock opions are warrans ha firms issue o employees as compensaion for services. Warrans are call opions on he firm s asses, no on is exising common equiy. Warrans have a fixed srike price and mauriy and are seled on exercise when he warran holder conveys he srike price o he firm and he firm issues addiional shares of sock o he warran holder. Warran exercise increases he firm s cash and, because warran holders only exercise warrans when hey are in he money, dilues is exising common equiy. In conras, opions are wrien and exercised ouside of he firm. Thus, opion exercise does no affec he firm s asses, liabiliies, or equiy. In addiion, whereas opions can be raded, employees canno sell or oherwise ransfer employee sock opions. Each of hese differences can cause opion values and employee sock opion, i.e., warran, values o diverge. 1 In addiion, warrans have implicaions for capial srucure ha opions do no. Tha he exercise of employee sock opions modifies he capial srucure of he firm is obvious. Opion exercise causes he firm o issue new shares of common sock and o receive he srike price in cash, hereby increasing boh he number of common shares ousanding and he oal asses of he firm. Less obvious are he capial srucure modificaions ha occur when he firm issues he opions. Finance heory shows ha issuing warrans increases he expeced value 1 Li and Wong (2005) esimaes ha he value of employee sock opions is oversaed by 6% when opion pricing models are used. In secion V, we also find ha employee sock opion value esimaes are oversaed when opion pricing models are used, alhough our mean oversaemen is larger 50%, i.e., 4% of marke value of common equiy compared o 6%. The difference in oversaemen esimaes may be aribuable o sample period or esimaion mehod. The Li and Wong (2005) sample period is 1996 hrough 2001, whereas ours is 2004 hrough 2009, which likely includes years of greaer equiy volailiy ha affecs opion values. Our esimaion mehod differs from ha in Li and Wong (2005) in ha we joinly esimae he volailiies and values of employee sock opions and common equiy. 6

9 of he firm s asses and decreases he expeced risk of and reurn on he firm s equiy (e.g., Daves and Ehrhard 2007). This occurs for hree reasons. Firs, employees pay for he opions wih heir services, leaving addiional cash in he firm ha can be used for oher purposes. 2 Second, he expeced exercise price of he opions is anicipaed by he firm and is claimans from he dae he firm issues he opions. Therefore, he expeced value of he firm s asses increases wih he number of employee sock opions issued; employee sock opions are an addiional, poenially diluive claim agains his larger expeced asse base. Third, he issuance of employee sock opions decreases he expeced risk of, and hus he expeced reurn on, exising common equiy. A decrease in common equiy risk and expeced reurn is consisen wih he opions having a de-levering effec on he firm s common equiy. Inuiively, his is wha would occur if he firm sold a fracion of is risky asses a curren value and invesed he proceeds in a riskless bond. When he firm receives he bond proceeds a mauriy, i will purchase addiional risky asses a heir value a ha ime. In his way, equiy holders are insulaed from asse risk beween he opions issue dae and exercise dae. Because our ineres is in deermining wheher employee sock opions have characerisics of liabiliies, our ess focus on he hird capial srucure effec. In paricular, if employee sock opions are associaed wih lower risk of and expeced reurn on common equiy, hen we infer ha he opions do no have characerisics of liabiliies. Liabiliies and equiy in financial reporing Alhough liabiliies and equiy are disinc financial saemen elemens, here is a lack of consensus among accounans as o wheher and how o draw a line beween liabiliies and 2 Opion compensaion procures labor resources ha are provided over he vesing service period. This is a key facor in he FASB s decision o require he gran-dae value of opions o be recognized as an expense over he vesing period. In addiion, opions affec he incenives of employees. We focus on he direc capial srucure effecs of opions, raher han on he incenive effecs. However, our ess include conrols for possible risk-aking incenive effecs. 7

10 equiy, and which ype of claim is embodied in employee sock opions. Achieving consensus on he disincion beween liabiliies and equiy and, hus, deermining which claims of he firm are classified in which caegory is crucial for he curren financial reporing model. The idenificaion of liabiliies is imporan for assessing solvency. In addiion, he disincion beween liabiliies and equiy has a direc subsequen effec on ne income afer iniial recogniion, changes in he recognized amouns of liabiliies are recognized in comprehensive income bu corresponding changes in equiy are no. 3 For example, if employee sock opions were classified as liabiliies, hen changes in he value of he opions are candidaes for recogniion as expenses. If hey are classified as equiy, hen changes in heir values are no candidaes for expense recogniion. Wihou a clear disincion beween he wo claims classificaions, perhaps he mos fundamenal financial reporing amoun earnings is illdefined. Early accouning heoriss presen conflicing views of liabiliies and equiy. Sprague (1907) advances a proprieary heory of he firm in which he separaion of liabiliies from equiy is necessary o assess solvency and deermine profiabiliy. In conras, Paon (1962) suggess ha deb and equiy claims are inherenly indisinguishable because all claimans paricipae o some exen in he risks and rewards of he firm. Assuming he profiabiliy of operaions is unaffeced by financing decisions, Paon (1962) reasons ha he classificaion of claims ino deb and equiy is arbirary and largely irrelevan as long as operaing profi, which excludes all capial financing coss, is separaely idenified. The curren financial reporing model is more 3 Deb capial mainenance coss are recognized in comprehensive income as ineres expense. Changes in he recognized amouns of liabiliies ha resul in expense recogniion include, bu are no limied o, accreion of issue discoun, amorizaion of issue premium, remeasuremen o fair value, and selemen or cancellaion a amouns ha differ from recognized liabiliy amouns a he ime of selemen. Because curren accouning heory and conceps provide ha equiy capial mainenance coss are no recognized as expenses, similar or corresponding equiy evens do no resul in expense recogniion. 8

11 consisen wih he former view; liabiliies are separaely defined and ne income reflecs he cos of deb capial, bu no he cos of equiy capial. However, he lack of consensus abou characerisics ha disinguish liabiliies and equiy is refleced in curren accouning sandards relaing o financial insrumens, which include over 60 pieces of lieraure ha have been called inconsisen (and) difficul o undersand and apply (FASB 2007, iii). The FASB s curren Concepual Framework defines liabiliies as probable fuure sacrifices of he firm s asses arising from a presen obligaion (FASB 1985, para. 35). This definiion ress primarily on wo facors: he exisence of a presen obligaion and he requiremen o ransfer he firm s asses in selemen. However, his definiion of liabiliies is subjec o criicism because deermining wheher a presen obligaion exiss is subjecive, and because he form of selemen is subjec o srucuring. For hese reasons, a growing body of lieraure advocaes changing he definiion of liabiliies o include all claims oher han common sock (e.g., Kirschenheier e al. 2004; Ohlson and Penman 2005). In a move oward his definiion, he FASB released Preliminary Views: Financial Insrumens wih Characerisics of Equiy ( Preliminary Views, FASB 2007) o solici commens on is proposal ha a basic ownership approach o equiy classificaion would improve financial reporing. The Preliminary Views noes ha disinguishing liabiliies from equiy by applying he curren definiion of liabiliies is subjecive, paricularly o complex insrumens wih coningen selemen oucomes. For example, under curren requiremens, a wrien call opion is classified as a liabiliy if i mus be seled wih cash, bu is classified as equiy if i can be seled wih shares. In conras o curren Generally Acceped Accouning Principles (GAAP), he basic ownership approach would classify as equiy only common sock, i.e., here would be only one ype of equiy. As a resul, preferred sock, opions, and oher coningen claims would 9

12 be classified as liabiliies under he FASB s proposed basic ownership approach, raher han as differen ypes of equiy. The basic ownership approach arguably is less subjecive and easier o apply han he curren definiion of liabiliies because i obviaes he need (1) o idenify he essenial characerisics of liabiliies and (2) o deermine wheher paricular insrumens have such characerisics. Under he basic ownership approach, liabiliies comprise any claim ha is no he basic ownership ineres, irrespecive of wheher he claim embodies a presen obligaion. However, defining equiy as only basic ownership ineress means ha liabiliies would be he residual caegory for claims agains he firm s asses. This is in conras o he curren definiion of equiy as he residual of asses minus liabiliies, and could lead o a classificaion sysem ha fails o reflec appropriaely hose characerisics of non-basic ownership claims ha affec he risk of and expeced reurn on he basic ownership ineress. Consisen wih hese concerns, criics of he basic ownership approach o equiy classificaion believe ha classifying as liabiliies boh presen obligaions and non-obligaing financing insrumens would resul in a heerogeneous class of liabiliies and an arificially narrow se of equiies ha will decrease he usefulness of he balance shee, boh for assessing a firm s solvency, and for valuing is residual claims (FASAC, 2001, page 388). 4 These criics believe ha he decision-usefulness of liabiliy and equiy classificaion derives from defining and idenifying liabiliies, no from defining and idenifying he mos basic ownership ineres. This need o idenify liabiliies is consisen wih he heoreical finance lieraure ha models risk of and expeced reurn on common equiy as a funcion of financial leverage (Hamada 1969; Rubinsein 1973). The imporance of leverage is demonsraed by he model in 4 Consisen wih his view, Terando e al. (2007) presens empirical evidence ha marke paricipans differenially value share pus based on heir solvency characerisics. 10

13 Robichek and Myers (1966), among ohers, which shows ha leverage can have a negaive effec on common equiy value when bankrupcy is possible, or when leverage affecs fuure invesmen and growh. These sudies concepualize liabiliies in erms of unavoidable obligaions o surrender firm asses in paricular saes of he world, and sugges ha disinguishing obligaions from oher claims is imporan for financial saemen analysis and assessing he risk and value of common equiy. The possibiliy ha financing consrains and bankrupcy coss can affec he value of equiy is inconsisen wih Paon s (1962) view of he eniy, which is based largely on he premise ha operaing and financing decisions are independen and ha financing decisions are irrelevan for valuaion of he firm. We posi ha if finance heory is empirically descripive, hen reporing liabiliies separaely from equiy and disaggregaing claims using a classificaion scheme based on heir idenifiable risk and reurn characerisics should be useful o invesors for valuing common equiy and for assessing is risk and expeced reurn. Wih regard o classificaion, several sudies view employee sock opions as more akin o liabiliies han o equiy (e.g., Clark 1993; Balsam 1994; Hull and Whie 2003; Kirschenheier e al. 2004; Maines e al. 2004; Ohlson and Penman 2005; Sacho and Oberholser 2005; Landsman e al. 2006). Some of hese sudies conend ha he curren financial reporing concepual framework requires opions o be classified as liabiliies because opions reflec claims of poenial owners raher han exising owners (e.g., Clark 1993). Ohers conend ha he issuance of opions creaes a condiional obligaion o issue common sock for less han is marke value in some poenial fuure saes of he world, ha hese condiional obligaions are sufficienly presen o mee he definiion of a liabiliy, and ha value esimaes derived from valuaion 11

14 models are he mos appropriae measures of hese obligaions a any reporing dae (Kirschenheier 2004; Ohlson and Penman 2005). However, he more prevalen raionale for classifying employee sock opions as liabiliies is he perspecive ha he exercise of opions resuls in a windfall gain o opion holders ha he firm should recognize as an expense. Because changes in he value of equiy are no recognized in ne income, his perspecive suggess ha recogniion in ne income of changes in opion value subsequen o he gran dae requires he opions o be classified as liabiliies. Inferring liabiliy or equiy classificaion from desired effecs on ne income would be a new approach o deermining financial saemen elemen classificaion. 5 Hull and Whie (2003) akes his perspecive o an exreme and expresses he view ha liabiliy or equiy classificaion is enirely irrelevan for employee sock opions, bu ha proper accouning requires expense recogniion of changes in he opion value subsequen o gran. 6 Lile exan empirical research aemps o idenify he characerisics of employee sock opions ha are relevan for deermining he appropriae classificaion of he opions in he saemen of financial posiion. Li and Wong (2005) and Landsman e al. (2006) documen ha employee sock opions mus be considered when using a residual income model o esimae he value of common equiy. This is because ne income accrues for he combined benefi of employee sock opion holders and common equiy holders, and failure o accoun for he fracion of income accruing for he benefi of opion holders causes he residual income model o oversae he esimaed value of equiy. Li and Wong (2005) approaches he problem by using oal residual income o esimae he combined value of employee sock opions and common 5 For example, preferred sock is classified as equiy. Preferred dividends are recognized as an expense in deermining ne income available o common equiy holders, bu no in deermining ne income. 6 Exercise dae value of employee sock opions is frequenly acceped as he real cos of compensaion. For example, Core, Guay, and Larcker (2008) finds ha negaive press coverage abou poenially excessive execuive compensaion focuses more on he proceeds from opion exercises han on gran-dae values. 12

15 equiy and hen subracing he opion value esimaed from a warran pricing model o derive an esimae of common equiy value. Landsman e al. (2006) evaluaes he relaive explanaory power of alernaive proforma mehods of accouning for employee sock opions, and finds ha subracing opion value from oal residual income over he erm of he opions increases he cross-secional explanaory power of he residual income model for common equiy value. 7 Landsman e al. (2006) concludes ha employee sock opions should be classified as liabiliies and changes in opion value each period should be included in ne income. However, as Aboody (2006) poins ou, he residual income model canno be used o assess he efficacy of alernaive mehods of accouning because if he residual income model is applied correcly, one should always be able o recover he value of common equiy. Thus, Landsman e al. (2006) can be viewed as a comparison of hypoheical valuaion errors ha would occur if invesors failed in specified ways o correcly incorporae available informaion when applying he residual income model. Alhough boh Li and Wong (2005) and Landsman e al. (2006) documen he imporance of separaely considering employee sock opion value when valuing common equiy, neiher direcly addresses he classificaion of employee sock opions as liabiliies or equiy based on he relaion beween he opions and he risk and reurn characerisics of common equiy. Similar o Kirschenheier e al. (2004), Landsman e al. (2006) infers liabiliy classificaion from he apparen need o accoun for he value of employee sock opions when valuing common equiy. In conras, we posi ha classificaion in he saemen of financial posiion should derive from capial srucure effecs, including risk and reurn. 8 7 Subracing esimaed opion value from oal residual income implicily assumes ha he esimaed opion value equals he expeced presen value of residual income accruing o opion holders. 8 Tha he residual income model is equivocal wih respec o liabiliy or equiy classificaion can be illusraed by considering a firm wih common equiy and raded warrans. For residual income o explain he curren value of he 13

16 We conribue o he debae abou he appropriae classificaion of employee sock opions by idenifying empirically hose characerisics ha differeniae liabiliies from common equiy. We show ha employee sock opions are negaively associaed wih common equiy risk and he expeced reurn on common equiy. Tha is, we show ha he effecs of employee sock opions on common equiy risk and expeced reurn are opposie o hose of deb deb is posiively associaed wih common equiy risk and expeced reurn. These findings sugges ha opions should no be classified as liabiliies. Relaion beween warrans and equiy risk and reurn Modigliani and Miller (1958) shows ha in he absence of axes and ransacion coss, alhough oal firm value is independen of leverage, he cos of equiy varies posiively wih he deb-o-equiy raio. Tha is, Modigliani and Miller (1958) shows ha a firm s equiy risk increases when i issues deb, and he expeced reurn on equiy reflecs a risk premium commensurae wih his increased risk. Exending he work of Modigliani and Miller (1958, 1963), Hamada (1972) empirically shows ha, in he cross-secion, realized equiy reurns are increasing in leverage. 9 However, he heoreical effecs of coningen claims on common equiy risk and reurn are no as sraighforward as are he effecs of sraigh deb. Ingersoll (1977) models he value of converible deb as a combinaion of he values of sraigh deb and a warran wih an exercise price equal o he amoun of implied sraigh deb. One implicaion of Ingersoll s (1977) model is ha he ne effec of converible deb on common equiy risk is a produc of wo counervailing warrans wihou error, he value of common equiy mus be deduced from residual income. However, we do no view his implying ha common equiy should be classified as a liabiliy when a firm has raded warrans. 9 More recen sudies esing he relaion beween leverage and equiy reurns repor conradicory resuls. For example, Penman e al. (2007) finds ha leverage is negaively relaed o realized equiy reurns and Koreweg (2004) finds ha equiy facor loadings decrease afer equiy-for-deb exchanges. Empirical deviaions from Modigliani and Miller (1958) are collecively referred o as he leverage puzzle. 14

17 forces: common equiy risk increases wih he implied amoun of sraigh deb and decreases wih he implied amoun of he warran. Galai and Schneller (1978) exends Ingersoll (1977) and develops a srucural model for separaely pricing warrans on levered common equiy. Consisen wih Ingersoll s (1977) analysis, Galai and Schneller s (1978) model predics ha he issuance of warrans decreases he risk of and expeced reurn on he firm s common equiy. Consisen wih Modigliani and Miller s (1958) resul for deb, warran valuaion models assume ha he issuance of warrans does no resul in a change o common equiy value (Ukhov 2004; Daves and Ehrhard 2007). Because warrans are seled by he firm receiving cash and issuing sock, he issuance of warrans a heir curren value is equivalen o he coningen sale of a fracion of he firm a is curren value in reurn for a riskless receivable. 10 Appendix A presens a numerical example o illusrae he implicaions of his heoreical lieraure. Inuiively, common equiy risk decreases as warrans ousanding increase because by issuing warrans he firm effecively sells a porion of he upside asse reurn poenial for is curren value. 11 This ransfer runcaes boh ails of he reurn disribuion for common equiy, hereby reducing he variance of is reurn. As Figure 1 in Appendix A shows, assuming here is no uncerainy, he issuance of warrans is idenical o a sock subscripion, and neiher he value of nor he expeced reurn on exising equiy changes. However, as Figure 2 in Appendix A shows, in he more realisic case of uncerainy, alhough he value of exising common equiy does no change when a firm issues warrans, he risk of and expeced reurn on exising common equiy boh decrease. 12 Tha is, he issuance of warrans de-levers common equiy. 10 By focusing our ess on common equiy risk and expeced reurn, we implicily assume ha he Modigliani and Miller (1958) capial srucure irrelevance proposiion holds, a leas on average. 11 In he example, his value is $ The deducibiliy of employee sock opion inrinsic value for ax purposes can provide ax benefis relaive o oher ypes of financing. As wih deb ax shields, hese sock opion ax benefis poenially furher reduce he cos of financing wih opions. We leave o fuure research he analysis of he relaion beween employee sock opion ax benefis and he value of and expeced reurn on common equiy. 15

18 Empirical esimaion of Galai and Schneller s (1978) model parameers requires knowledge of he value of he firm s asses and he variance of he asses reurn, boh of which are unobservable. Largely as a resul of he idenificaion problem his lack of observabiliy poses, he empirical validiy of Galai and Schneller s (1978) pricing model remains an open quesion (e.g., Noreen and Wolfson 1981; Galai 1989). As a soluion o he idenificaion problem, Ukhov (2004) develops an algorihm using only observable inpus for pricing warrans on levered common equiy and for deermining he variance of he warrans reurn. The Ukhov (2004) algorihm can be solved numerically, and provides a mechanism for compuing he price and he variance of each of class of claims for a firm wih a complex capial srucure. More recenly, as Appendix B explains, Daves and Ehrhard (2007) shows how o compue he expeced reurn on various capial srucure componens using observable daa. We use he Daves and Ehrhard (2007) mehodology o compue he value of and expeced reurn on employee sock opions in Secion V. Despie he heoreical basis for expecing ha warrans de-lever common equiy, he associaion beween warrans and he risk of and expeced reurn on common equiy have no been esablished empirically. The heoreical models are based on assumpions, which may no be descripively valid, paricularly for employee sock opions. For example, employee sock opions frequenly are issued o insiders who may have he abiliy o influence he firm o amend heir opion conracs afer issuance. Such implici conracual erms may creae conracs ha do no mee he definiion of a warran. Repricing he opions is an example of such an opion conrac amendmen because repricing negaes he fixed srike price feaure of a warran. In addiion, he warran models assume markes are complee, and he inabiliy of employees o sell heir opions is a form of marke incompleeness wih unclear implicaions for he models 16

19 predicions. Moreover, disribuional assumpions underlying he models predicions migh no be descripive (Galai 1989). Therefore, esing he predicions of he models is necessary if he heoreical effecs of warrans on common equiy are o be used as a basis for heir financial saemen classificaion. 13 We conribue o his lieraure by esing he predicions of he warran valuaion models as hey relae o employee sock opions. Tha is, in conras o deb, employee sock opions are prediced o be negaively associaed wih he risk of and expeced reurn on common equiy. We also provide evidence on how changes in he values of employee sock opions and common equiy correspond o changes in he firm s asse value, and on he magniude of he expeced reurns on hese wo ypes of claims. Consisen wih he models predicions, we find ha as he firm s disance o defaul increases, he sensiiviies of common equiy and employee sock opion values o changes in asse value increases, and he sensiiviy of deb value o changes in asse value decreases. Tha is, common equiy and employee sock opion values are convex in asse value, and liabiliy values are concave. We also find ha he expeced reurn on employee sock opions is on average 70% greaer han he expeced reurn on common equiy, which is inconsisen wih employee sock opions being a claim agains a firm s asses wih higher prioriy han common equiy. Common equiy risk III. RESEARCH DESIGN We firs es wheher common equiy risk is negaively associaed wih he exen of ousanding employee sock opions, as prediced by finance heory. To do so, we esimae equaion (1), using wo measures of equiy risk, RISK. 13 For example, evidence from empirical validaion of he Black-Scholes (1973) opion pricing model indicaes ha he model is generally descripive. However, marke prices frequenly deviae from hose prediced by he model (see Mayhew 1995 for discussion). In general, he model does no perform well for opions ha are far ou of he money. 17

20 RISK = β + β OPTIONS + β LEVERAGE + β CREDITRISK + β SIZE + β EARN (1) + β 6CHANGE _ EARN + β7growth + β8propensity + β9change _ RD + ε Our firs measure of RISK is he annualized sandard deviaion of he logarihm of monhly sock reurns, EQUITYVOL. The second is equiy volailiy implied by he prices of a firm s raded opions, IMPLIEDVOL. Specifically, IMPLIEDVOL is he average of he implied volailiies from he firm s call and pu opions wih he longes mauriy and srike price closes o he firm s sock price. Because no all firms have raded opions, we esimae equaion (1) using IMPLIEDVOL as he measure of equiy risk based on a smaller sample. We esimae EQUITYVOL using reurns over year + 1, and IMPLIEDVOL a he end of year. We measure all oher variables in equaion (1), and equaion (2) below, a he end of year or during year, depending on he naure of he variable. Our primary ineres is in he coefficien on he exen o which he firm has ousanding employee opions, i.e., β 1, he coefficien on OPTIONS. OPTIONS is he number of employee sock opions ousanding divided by he sum of common shares ousanding and employee sock opions ousanding. We predic a negaive coefficien on OPTIONS if employee opions decrease he risk of common equiy. Equaion (1) includes several variables as conrols for facors known o be associaed wih equiy risk. We include LEVERAGE, he raio of curren plus long-erm deb o he sum of deb and he marke value of common equiy, as a conrol for he amoun of sraigh deb in he firm s capial srucure. Consisen wih Modigliani and Miller (1958), we expec ha equiy risk is posiively associaed wih leverage. Because leverage is only one componen of defaul risk, we also include CREDITRISK as a conrol for credi risk. CREDITRISK is he firm s fied bond raing esimaed from a bond raing regression (Barh, Beaver, and Landsman 1998; Barh, 18

21 Hodder, and Subben 2008). 14 Specifically, we esimae he relaion beween a firm s credi raing and financial saemen variables, i.e., asses, reurn on asses, leverage, and indicaor variables for wheher a firm pays dividends, has subordinaed deb, and repors negaive earnings, for he subsample of firms wih credi raings. 15 We hen apply he esimaed coefficiens from his relaion o he financial saemens amouns of he sample firms o obain fied values for credi risk. We expec ha credi risk is posiively associaed wih equiy risk. Prior research finds a negaive relaion beween firm size and equiy risk (Pasor and Veronesi 2003). Thus, we include in equaion (1) SIZE, which is he naural logarihm of he marke value of equiy, and expec i has a negaive associaion wih equiy risk. Hanlon, Rajgopal, and Shevlin (2004) finds ha operaing performance is negaively associaed wih equiy volailiy in he cross-secion. Thus, we include in equaion (1) earnings, EARN, and change in earnings, CHANGE_EARN, as conrols for operaing performance. EARN is annual income before exraordinary iems divided by oal asses, and CHANGE_EARN is he change in EARN from year 1 o year. We expec EARN is negaively associaed wih equiy risk. We do no predic he sign of he associaion for CHANGE_EARN; CHANGE_EARN may reflec operaing performance ha is negaively associaed wih equiy risk or shor-erm growh ha is posiively associaed wih equiy risk. Because higher long-erm growh ypically is associaed wih higher risk and can provide opporuniies for managers o profi from equiy-based compensaion, we include GROWTH, he las consensus long-erm earnings growh forecas, in equaion (1) as a conrol for growh. In addiion, Core and Guay (2001) finds ha firms wih more growh opporuniies gran opions 14 Our abulaed findings are based on esimaing he bond raing regression pooling observaions over ime. Esimaing he regression separaely year by year does no aler our inferences. 15 During our sample period, recogniion of sock-based compensaion expense became mandaory. Thus, o miigae he poenial for confounded coefficien esimaes, we calculae reurn on asses using ne income before sock-based compensaion expense. 19

22 more frequenly, suggesing GROWTH is likely o be posiively correlaed wih OPTIONS. Thus, failure o include a conrol for growh could bias he coefficien on OPTIONS. We expec GROWTH is posiively associaed wih equiy risk. Firms selec wheher o issue employee sock opions, and here is evidence ha firms wih greaer operaing risk and more growh opporuniies are more likely o issue opions. Alhough we include GROWTH as a conrol for firms propensiy o issue opions, and SIZE and CHANGE_EARN can reflec operaing risk, here could be oher facors associaed wih OPTIONS and RISK ha are no capured by hese variables. Thus, we include in equaion (1) PROPENSITY as a conrol for firms propensiy o issue opions. We measure PROPENSITY based on Core and Guay (2001). In paricular, we esimae year by year he relaion beween OPTIONS and he naural logarihm of he sum of marke value of equiy and book value of deb, he naural logarihm of he number of employees, equiy volailiy, he book-o-marke raio, research and developmen expense divided by oal asses, and indusry effecs. 16 PROPENSITY is he prediced value from his relaion. We expec a firm s propensiy o issue opions is posiively associaed wih equiy risk. Finally, opions can provide incenives for managers o increase he risk of he firm s asses (DeFusco e al. 1990; Rajgopal and Shevlin 2002; Williams and Rao 2006). 17 As a conrol for subsequen risky invesmen, we include in equaion (1) CHANGE_RD (Coles e al. 2006). 16 The relaion in Core and Guay (2001) also includes segmen informaion as measures of oal diversificaion and geographic diversificaion. Because requiring he use of segmen informaion dramaically reduces our sample size, we do no use segmen informaion when consrucing our propensiy measure. However, unabulaed analyses reveal ha a propensiy measure ha includes segmen informaion is 99% correlaed wih our propensiy measure. No surprisingly given his high correlaion, our inferences are unchanged when we esimae equaion (1) using he alernaive propensiy measure and he subsample of firms wih available segmen daa. 17 Lamber, Larcker, and Verrecchia (1991) shows analyically ha opions can, for paricular parameer values, decrease risk-aking incenives. Alhough he expeced value of opion payoffs increases wih asse volailiy, opions are risky asses, and risk-averse, undiversified execuives can become more risk-averse if opions are a large componen of compensaion (Carpener 2000). Thus, he associaion beween opions and risk-aking is siuaional. 20

23 CHANGE_RD is he year + 1 research and developmen expense divided by oal asses minus year s research and developmen expense divided by oal asses. We expec ha an increase in risky invesmen is posiively associaed wih equiy risk. Expeced reurn on common equiy We nex es wheher he expeced reurn on common equiy is negaively associaed wih he exen of ousanding employee sock opions, also as prediced by finance heory. To do so, we esimae equaion (2). ECC = β + β OPTIONS + β LEVERAGE + β SIZE + β BM + β BETA + β MOM (2) + β GROWTH + β DISPERSION + ε 7 8 ECC is he expeced cos of common equiy a he end of year. Our esimae of ECC is based on he Fama and French (1993) hree-facor model supplemened wih he momenum facor, ime-varying facor loadings, risk-free ineres raes, and risk premiums. We calculae ECC following Barh, Konchichki, and Landsman (2010) by firs esimaing facor beas for each firm using five-year rolling windows, updaed annually, and hen using hese esimaed beas, along wih expeced facor reurns based on hisorical averages, o esimae ECC. As wih equaion (1), our primary ineres is in he coefficien on OPTIONS, β 1. We predic i is negaive. Equaion (2) also includes as conrol variables proxies for facors commonly associaed wih expeced reurns. As wih equaion (1), we include LEVERAGE in equaion (2) and expec a posiive associaion beween leverage and expeced equiy cos of capial. Based on prior empirical sudies, we also expec he cos of equiy capial o be negaively associaed wih firm size, SIZE, and o be posiively associaed wih he firm s equiy book-o-marke raio, BM, and sock reurn bea, BETA (e.g., Fama and French 1993). BM is he naural logarihm of he book value of equiy divided by he marke value of equiy. BETA is he coefficien on he marke 21

24 reurn from firm-specific esimaion of he relaion beween a firm s monhly reurns and he marke reurn, using five-year rolling windows. 18 Jegadeesh and Timan (1993) examines price momenum and finds ha pas winners earn subsanially higher reurns han pas losers. Thus, we include price momenum, MOM, in equaion (2) and expec i has a posiive associaion wih expeced equiy cos of capial. MOM is he firm s raw reurn over he firs en monhs of year. Beaver, Keler, and Scholes (1970) posis ha high growh firms are more profiable because abnormal profis erode over ime as a resul of compeiion. Thus, we include GROWTH in equaion (2) and expec a posiive associaion beween growh and expeced equiy cos of capial. Finally, because informaion risk is posiively associaed wih cos of equiy capial (Boosan and Plumlee 2005), we include DISPERSION in equaion (2). DISPERSION is he coefficien of variaion of year earnings forecass ousanding in June of year. We predic a posiive associaion beween analys forecas dispersion and expeced equiy cos of capial. IV. DATA AND FINDINGS FOR EQUITY RISK AND EXPECTED RETURN Daa and descripive saisics We base our ess on a sample of U.S. firms over he period 2004 o Our sample begins in 2004 because his is he firs year employee sock opion daa are available on Compusa for a broad se of firms. We obain sock prices and reurns from CRSP and analys forecass from I/B/E/S. We calculae implied equiy volailiy using daa from Opionmerics and he approach in Barov, Mohanram, and Nissim (2007). We esimae equaions (1) and (2) using he pooled cross-secional sample and base repored -saisics on sandard errors clusered 18 BETA is a proxy for sysemaic risk and opions can increase sysemaic risk, idiosyncraic risk, or boh. Marke bea also is heoreically relaed o leverage. Our including BETA in equaion (2) in addiion o LEVERAGE is consisen wih prior research examining he deerminans of ECC. Excluding BETA from equaion (2) has no effec on our inferences. 22

25 by firm and year o miigae ineremporal and cross-secional correlaion of residuals (Gow, Ormazabal, and Taylor 2010). We esimae several versions of equaions (1) and (2) using differen combinaions of he explanaory variables. We do so in par because lack of daa reduces he number of observaions available for some variables. Table 1, Panel A, presens descripive saisics for each variable we use in our analyses. Regarding our measures of equiy risk and expeced reurn, Panel A reveals ha realized equiy volailiy, EQUITYVOL, averages 47%, and implied volailiy, IMPLIEDVOL, averages 45%. Panel A also reveals ha he mean of expeced equiy cos of capial, ECC, is 13%. Panel A reveals ha he mean of OPTIONS is 0.08, which indicaes ha he average raio of opions ousanding o he oal of common equiy shares and opion ousanding is 8%. This is slighly larger han he 6.4% repored by Core and Guay (2001) over an earlier sample period and is consisen wih he use of opions increasing over ime. 19 Regarding he conrol variables, Panel A reveals ha he mean of LEVERAGE is 21% of he sum of he marke value of equiy and deb. This raio is consisen wih he findings of Barh, Hodder, and Subben (2008). 20 The means of earnings, EARN, and change in earnings, CHANGE_EARN, are negaive, bu he medians are no. The mean (median) of EARN is 16% (1%) and of CHANGE_EARN is 1% (0%). The lef skewness of earnings is consisen wih prior research (e.g., Ball, Sadka, and Sadka 2009). Panel B of Table 1 presens he Pearson correlaions beween he variables. Mos of he correlaions are as expeced. For example, he correlaion beween EQUITYVOL and IMPLIEDVOL is large and posiive (Pearson Corr. = 0.60; Spearman Corr. = 0.70). In addiion, 19 Because Core and Guay (2001) repors opions divided by common shares, for ease of comparison, we conver he raio in Core and Guay (2001) o he raio we use. 20 Barh, Hodder and Subben (2008) measures leverage as he raio of deb o oal asses. Our inferences are invarian o using his alernaive measure of leverage. 23

26 consisen wih heory, boh measures of risk are posiively correlaed wih CREDITRISK and GROWTH (Pearson Corr. = 0.36 and 0.45 for CREDITRISK; 0.19 and 0.24 for GROWTH), and negaively correlaed wih SIZE (Corr. = 0.36 and 0.56), EARN (Corr. = 0.36 and 0.37), and CHANGE_EARN (Corr. = 0.11 and 0.06), consisen wih he findings of Hanlon, Rajgopal, and Shevlin (2004). Also as expeced, PROPENSITY is posiively correlaed wih EQUITYVOL and IMPLIEDVOL (Corr. = 0.15 and 0.18). Alhough he univariae correlaions generally are supporive of our predicions, we base our inferences on he mulivariae relaions specified by equaions (1) and (2). Findings: Employee sock opions and equiy risk Table 2, Panel A, presens regression summary saisics from esimaing four versions of equaion (1). Consisen wih our predicion he coefficien on OPTIONS is significanly negaive in all specificaions, wih -saisics of 3.32, 4.16, 3.36, and Tha is, he exen o which a firm has ousanding employee sock opions is significanly negaively associaed wih equiy risk, as measured by realized equiy volailiy. Panel A also reveals ha leverage is significanly posiively associaed wih equiy volailiy in all specificaions ( = 5.72, 6.85, 5.96, and 5.66). Finding a significan posiive associaion beween leverage and equiy volailiy coupled wih finding a significan negaive associaion beween employee sock opions and equiy volailiy indicaes ha employee sock opions de-lever he firm s equiy, as prediced. Regarding he oher conrol variables, Panel A reveals, as expeced, ha CREDITRISK is posiively associaed wih equiy risk in all versions, alhough he associaion is only marginally significan in he version ha includes GROWTH ( = 3.73, 1.74, 10.49, and 3.55). Also as expeced, SIZE is significanly negaively associaed wih equiy volailiy ( = 6.34, 6.33, and 24

27 6.22). In all specificaions, earnings, EARN, is significanly negaively associaed wih equiy volailiy, consisen wih he findings of Hanlon, Rajgopal, and Shevlin (2004) ( = 10.89, 8.34, 11.13, and 10.92). The coefficien on change in earnings, CHANGE_EARN, is significanly posiive in wo of he specificaions ( = 2.27, 0.72, 2.62, and 1.44). The sign of he coefficien on CHANGE_EARN is sensiive o he inclusion of GROWTH, which suggess ha CHANGE_EARN also is a proxy for growh. Consisen wih growh reflecing greaer risk, GROWTH is significanly posiively associaed wih equiy volailiy ( = 7.96). The coefficien on fuure risk aking, represened by CHANGE_RD, is also significanly posiive ( = 2.65). Panel A also reveals ha PROPENSITY is no significanly associaed wih equiy volailiy, incremenal o he oher variables ( = 1.02). 21 Table 2, Panel B, presens regression summary saisics from esimaing equaion (1) wih implied volailiy, IMPLIEDVOL, as he measure of equiy risk. Panel B reveals inferences idenical o hose revealed by Panel A wih respec o he relaion beween equiy risk and employee sock opions. In paricular, he coefficien on OPTIONS is significanly negaive in all four specificaions of equaion (1), wih -saisics ranging from 4.53 o Regarding he conrol variables, Panel B reveals ha, as expeced, SIZE and EARN are consisenly negaively associaed wih implied volailiy, wih -saisics ranging from 7.93 o LEVERAGE is significan in all specificaions ( = 2.43, 4.24, 2.87 and 2.44). However, he significance of CREDITRISK depends on he inclusion of SIZE. When SIZE is included in he equaion he coefficiens on CREDITRISK are no significanly differen from zero; he - 21 Table 1, Panel B, reveals ha PROPENSITY is posiively correlaed wih EQUITYVOL (Corr. = 0.15) and wih OPTIONS (Corr. = 0.53). This suggess ha he associaion beween PROPENSITY and EQUITYVOL is subsumed by oher variables in he esimaion equaion. Consisen wih his conjecure, unabulaed findings from esimaing equaion (1) wih only PROPENSITY and OPTIONS as explanaory variables reveal ha PROPENSITY is significanly posiively associaed wih EQUITYVOL, and OPTIONS is significanly negaively associaed wih EQUITYVOL. Unabulaed findings using IMPLIEDVOL as he dependen variable reveal he same inferences as he unabulaed findings using EQUITYVOL. 25

28 saisics are all less han or equal o 0.66 in absolue value. When SIZE is no included, he coefficien on CREDITRISK is significanly posiive, as expeced ( = 10.62). Also as expeced, he coefficien on GROWTH is significanly posiive ( = 8.55) and hose on CHANGE_EARN are significanly posiive, excep when GROWTH is included in he equaion ( =2.49, 0.30, 2.94, and 2.22). The oher conrol variables are no significanly associaed wih implied volailiy. Relaion across opion aribues The poenial for managers o increase he cerainy of opion payous by reducing he srike price of he opions, and he long erm of employee sock opions relaive o oher warrans are wo characerisics ha disinguish employee sock opions from oher warrans and ha poenially invalidae he heoreical models upon which we base our predicions. Specifically, he role of OPTIONS in a firm s capial srucure should be more similar o liabiliies and less similar o equiy when 1) he opions pose greaer risk o he common equiy holders because he opion srike price is lowered, hereby making opion payous more cerain, or 2) he opions are longer erm and herefore have less of a de-levering effec on common equiy (Schulz and Traumann 1994). Thus, o provide addiional suppor for our primary findings and inferences, we invesigae wheher he relaion beween RISK and OPTIONS varies predicably wih hese aribues of he employee sock opions. To examine he effecs of increased cerainy of opion payous associaed wih expeced srike price reducions, we examine he associaion beween opion repricing and he relaion beween RISK and OPTIONS. Repricing is he pracice of reseing he srike price on a sock opion conrac, ypically afer he sock price declines. We collec repricing daa from ExecuComp and Equilar, and we se an indicaor variable, REPRICE, equal o one in he year a 26

29 firm reprices opions for a leas one execuive, and zero oherwise. 22 Because we expec ha he relaion beween employee sock opions and common equiy risk is less negaive when firms have a endency o reprice opions, we predic a posiive coefficien on he ineracion of REPRICE and OPTIONS. Warran value is mos sensiive o asse value changes for near-mauriy, in-he-money warrans; herefore, warran volailiy increases as ime o mauriy decreases. Because asse volailiy is a weighed average of warran volailiy and common equiy volailiy, for any given level of asse volailiy, common equiy volailiy decreases as warran volailiy increases. This implies ha common equiy volailiy should decrease as he ime o mauriy of employee sock opions decreases. To examine he effecs of longer opion erms on he relaion beween RISK and OPTIONS, we se an indicaor variable, AVG_TERM, equal o one if he average erm of opions ousanding is above he sample median, and zero oherwise. We esimae he average life remaining for ousanding opions using each firm s disclosed expeced life of newly graned opions. Following Landsman e al. (2006), we assume ha he average life for all opions ousanding equals one-half of he expeced life of newly graned opions. Because longer-erm opions have less effec on he risk of and expeced reurn on common equiy, we predic a posiive coefficien on he ineracion of AVG_TERM and OPTIONS. Table 2, Panel C, presens he findings. The firs four columns presen findings from using realized volailiy, EQUITYVOL, as he risk measure, and he las four columns presen findings using implied volailiy, IMPLIEDVOL. Consisen wih predicions, he findings relaing o repricing in Panel C reveal ha he relaion beween OPTIONS and RISK is 22 This analysis is based on firms covered by ExecuComp, i.e., curren and former members of he S&P 1500 plus some requess by cliens of S&P. Equilar idenifies some repricing firms ha ExecuComp does no. Thus, we use boh sources o idenify repricing firms o increase he power of our ess. Using only ExecuComp o idenify repricing firms does no aler our inferences. 27

30 significanly less negaive for firms ha reprice opions ( = 2.56 and 2.83 for EQUITYVOL and IMPLIEDVOL). In addiion, unabulaed findings reveal ha he oal coefficien on OPTIONS for firms ha reprice opions, i.e., he sum of he coefficiens on OPTIONS and OPTIONS REPRICE, is no significanly differen from zero ( = 1.44 and 1.46 for EQUITYVOL and IMPLIEDVOL). These findings sugges ha opion repricing changes he characerisics of employee sock opions such ha he opions no longer have characerisics of equiy. Relaing o longer opion erms, Panel C also reveals, as prediced, ha he relaion beween OPTIONS and RISK is mued when he remaining average employee sock opion erm o mauriy is above he sample median. The posiive coefficien on he ineracion variable, OPTIONS AVG_TERM, indicaes ha he relaion is significanly less negaive for boh risk proxies ( = 2.25 and 1.90 for EQUITYVOL and IMPLIEDVOL). However, unabulaed findings reveal ha he oal coefficien on OPTIONS for firms wih longer-erm opions, i.e., he sum of he coefficiens on OPTIONS and OPTIONS AVG_TERM, is significanly negaive for boh risk proxies ( = 2.05 and 4.24 for EQUITYVOL and IMPLIEDVOL). These findings sugges ha alhough longer-erm employee sock opions have characerisics somewha less similar o warrans han shorer-erm opions, hey do no have characerisics of liabiliies. Taken ogeher, he resuls in Table 2, Panel C, are consisen wih he predicions of heory: employee sock opions wih conracual erms closer o rue warrans exhibi sronger negaive associaions wih equiy risk. Robusness checks We conduc four addiional ess o check he robusness of our inferences. Unabulaed findings from all robusness checks suppor he inferences we obain from he abulaed findings. 28

31 Firs, because here are few esablished models of he deerminans of equiy volailiy, our empirical specificaion of equaion (1) is necessarily ad hoc. Thus, o invesigae he robusness of our inferences, we include in equaion (1) boh wih EQUITYVOL and wih IMPLIEDVOL as he dependen variable several addiional variables shown by prior research o be associaed wih common equiy risk or reurn. Specifically, we include he equiy book-omarke raio, momenum, analys forecas dispersion, he inverse of price per share, and firm age as addiional explanaory variables. The unabulaed findings reveal ha alhough he significance of he associaion beween common equiy risk and some of conrol variables, including CHANGE_EARN, differs when hese addiional variables are included in he esimaing equaion, he associaion beween common equiy risk and OPTIONS is consisenly significanly negaive. Second, because our resuls could be unduly influenced by he unusually high marke volailiy in 2008, we re-esimae our equaions excluding observaions from Third, as an alernaive conrol for he propensiy o issue opions, we include opion grans in he preceding year. Fourh, we es wheher resuls are sensiive o our measuring OPTIONS as he percenage of diluion, i.e., he number of opions ousanding relaive o he oal of numbers of common shares and opions ousanding. In paricular, we measure OPTIONS as heir esimaed value, raher han as he percenage diluion. Findings: Employee sock opions and expeced reurn on equiy Table 3 presens regression summary saisics from esimaing wo versions of equaion (2). Consisen wih our findings for equiy risk, saisics in Table 3 from boh versions reveal ha OPTIONS is negaively associaed wih he expeced equiy cos of capial, ECC ( = 2.95 and 4.55). Consisen wih he equiy volailiy findings, he associaion beween ECC and 29

32 LEVERAGE is posiive, alhough i is only significanly so when we include GROWTH and DISPERSION in he equaion ( = 1.44 and 3.96). As expeced, SIZE is significanly negaively associaed wih ECC ( = 3.62 and 5.81) and BETA is significanly posiively associaed ( = 4.29 and 2.78). BM and DISPERSION are no significanly associaed wih ECC ( = 1.55 and 1.28 for BM, and 1.44 for DISPERSION) and, conrary o expecaions, MOM is significanly negaively associaed ( = 4.93 and 2.54). V. SENSITIVITY OF CLAIMS VALUES TO CHANGES IN ASSET VALUES Finance heory suggess ha deb and equiy values respond differenly o changes in asse value. In paricular, as he value of he firm s asses exceeds he value of deb by a larger margin, he sensiiviy of deb value o changes in asse value approaches zero and he sensiiviy of equiy value o changes in asse value approaches one (Meron, 1974). Therefore, if he sensiiviy o changes in asse value of he value of employee sock opions is more similar o equiy han i is o deb, hen he sensiiviy of opion value o changes in asse value should be closer o one (zero) for firms furher from (closer o) deb defaul. As a es of his relaion, we presen evidence on he sensiiviy of he change in he value of liabiliies, MVL, equiy, MVE, and employee sock opions, MVO, o changes in he value of asses, MVA, for firms wih differen disances o defaul on heir deb. We also provide evidence on he expeced reurn on opions, RET_OPT. We base our esimaes of opion value and expeced reurn on he approach in Daves and Ehrhard (2007), as oulined in Appendix B. Daves and Ehrhard (2007) shows how o compue capial componens values and required reurns using only marke observables. Specifically, using EQUITYVOL, common shares ousanding, and employee sock opion disclosure daa from Compusa, we firs simulaneously solve equaions (B3) hrough (B6) in Appendix B o 30

33 obain esimaes of opion value and he parial derivaive of opion value wih respec o share price. We hen inpu hose esimaes, combined wih share price, ECC, and he risk-free ineres rae, ino equaion (B6) in he Appendix o obain an esimae of he reurn on opions, RET_OPT. To esimae he values of asses and liabiliies, we use he procedure described in Barh, Hodder, and Subben (2008), which builds on Meron (1974) and Hillegeis e al. (2004). Given observed equiy value and hisorical sock reurn volailiy, we inver he Meron (1974) model o esimae he value of asses, which is hen used o esimae he value of liabiliies. For purposes of comparison, we also esimae he value of employee sock opions using he Black-Scholes (1973) opion pricing formula, based on inpus from he employee sock opion disclosure daa from Compusa; namely, average exercise price, expeced sock reurn volailiy, risk-free ineres rae, expeced dividend yield, and ime o mauriy. We follow Landsman e al. (2006) o esimae he average life for opions ousanding. Table 4, Panel A, presens disribuional saisics for and Panel B presens correlaions beween he variables we consruc. We refer o he Daves and Ehrhard (2007) esimae of he value of employee sock opions as he D-E value, and he Black-Scholes (1973) esimae as he B-S value, boh scaled by marke value of common equiy. The esimaion mehods differ mos wih respec o heir reamen of diluion and leverage. 23 How large differences are is an empirical quesion. Panel A reveals ha he mean B-S value of employee opions is 6% of he marke value of common equiy and he mean D-E value is 4%. These saisics indicae ha he Black-Scholes (1973) formula resuls in values of employee sock opions ha are oversaed by approximaely 50% when diluion is ignored. Consisen wih he greaer risk of employee sock 23 The Black-Scholes (1973) opion pricing model is frequenly used by firms o esimae he value of employee opions a he gran dae (Aboody, Barh, and Kasznik 2006; Landsman e al. 2006). The binomial pricing model is anoher common mehod used o esimae opion value. As commonly applied, neiher of hese mehods adjuss for he effecs of diluion or considers deb in he capial srucure. Appendix A shows how he binomial model can be adjused for diluion and leverage. 31

34 opions, he mean expeced reurn on opions, RET_OPT, of 22% is subsanially higher han he mean expeced equiy cos of capial, ECC, of 13%. Addiional descripive saisics presened in Panel B reveal ha B-S value and D-E value are posiively correlaed, alhough no highly (Corr. = 0.14). Panel B also reveals ha, conrary o heory, B-S value is negaively correlaed wih BETA (Corr. = 0.20). This is no he case for D-E value, which is posiively correlaed wih BETA (Corr. = 0.17). B-S value is posiively correlaed wih LEVERAGE (Corr. = 0.08) and D-E value is negaively correlaed wih LEVERAGE (Corr. = 0.26). Neiher value esimae is highly correlaed wih equiy volailiy, EQUITYVOL. 24 Consisen wih heory, he D-E required reurn on opions, RET_OPT, is posiively correlaed wih BETA (Corr. = 0.12). RET_OPT is posiively correlaed wih EQUITYVOL by consrucion. Overall, he saisics in Table 4 indicae ha D-E value and RET_OPT are consisen wih he heory from which hey are derived. Table 5 presens saisics ha enable us o assess he sensiiviy o changes in asse value of equiy value, liabiliy value, and employee opion value as he disance o defaul increases. Panel A presens he median raio of he change in he values of equiy, deb, and opions o he change in asse value by disance-o-defaul quinile. We define disance o defaul as he excess of asse marke value over liabiliy book value, scaled by he marke value of asses. As expeced, Panel A reveals ha he uni change in equiy value per uni change in asse value monoonically decreases as he disance o defaul increases (0.98 for quinile 5 o 0.73 for quinile 1). Also as expeced, Panel A reveals he opposie for deb ha is, he uni change in deb value per uni change in asse value monoonically increases as he disance o defaul increases ( 0.02 for quinile 5 o 0.25 for quinile 1). These relaions are consisen wih Meron 24 Recall ha he value of a warran is increasing in he volailiy of firm asses and decreasing in leverage. Leverage increases he volailiy of equiy bu no necessarily he volailiy of asses. Therefore, he value of warrans is no necessarily increasing in he volailiy of common equiy. 32

35 (1974), which shows ha as he probabiliy of defaul increases oward cerainy, deb holders become claimans on he firm s asses and, hus, effecively equiy holders. More imporanly for our research quesion, as prediced, Panel A reveals ha he change in D-E value exhibis a convex paern ha is similar o ha of equiy value and opposie ha of deb value. Namely, D-E value decreases monoonically in he change in asse value as he disance o defaul decreases (0.06 for quinile 5 o 0.01 for quinile 1). To es wheher hese paerns are significan, we esimae he relaion beween each of he value sensiiviies and disance o defaul. Table 5, Panel B, presens he findings. I reveals ha he sensiiviy of common equiy value and opion value o changes in asse value each is significanly posiive ( = 5.16 for equiy value and 8.67 for opion value). In conras, he sensiiviy of liabiliy value o changes in asse value is significanly negaive ( = 5.24). Taken ogeher, he findings in Table 5 provide corroboraive evidence ha employee sock opions share more in common wih equiy han wih deb. This, oo, suggess ha opions would be more appropriaely classified as equiy, no liabiliies, for financial reporing purposes. VI. SUMMARY AND CONCLUDING REMARKS This sudy seeks o deermine wheher employee sock opions have characerisics of liabiliies or of equiy. We focus our ess on how he opions relae o he risk of and expeced reurn on firms common equiy. Based on previously unesed finance heory we predic ha because employee sock opions are warrans issued and seled by he firm, he presence of employee sock opions is associaed wih boh lower risk of and expeced reurn on common equiy. Our evidence suppors his predicion. In paricular, we find ha realized common equiy reurn volailiy, he volailiy implied by a firm s raded opions, and expeced equiy cos 33

36 of capial all are negaively associaed wih he exen o which firms have ousanding employee sock opions. Consisen wih he heory upon which our ess are based, we find ha he relaion beween employee sock opions and he risk of common equiy is significanly less negaive for firms wih longer-erm opions and for firms ha reprice opions. These findings indicae ha he relaion beween common equiy and opions wih hese aribues is more like deb han i is for opions wihou hese aribues. For firms wih longer-erm opions, he relaion beween employee sock opions and common equiy risk is mued bu significanly negaive, which indicaes ha hese opions are only somewha more like deb in he capial srucure han shorer-erm opions. However, for firms ha reprice opions, he relaion beween opions and common equiy risk is posiive, which indicaes ha hese opions have characerisics of deb, no equiy. These findings reveal ha some employee sock opions have erms ha negae he equiy-like characerisics of warrans. We also find ha he sensiiviy of he value of employee sock opions o changes in asse value is similar o ha of equiy value and he opposie o ha of deb value. In addiion, our descripive evidence shows ha employee sock opions have much higher risk and expeced reurn han common equiy; he expeced reurn for opions is approximaely 70% larger han he expeced reurn on common equiy. Our findings conribue no only o he finance lieraure by empirically validaing he predicions of warran pricing heory, bu also o he debae abou wha characerisics should disinguish liabiliies and equiy for financial reporing purposes. Our findings demonsrae ha employee sock opions de-lever common equiy, no lever i. Our findings also demonsrae ha employee sock opions have higher risk and higher expeced reurn han common equiy claims 34

37 agains he same asses. Thus, he findings sugges ha hese opion claims are more residual han common equiy claims and, as a resul, ha hese opions essenially form a second ype of equiy. Taken ogeher, our findings are no consisen wih classifying employee sock opions as liabiliies for financial reporing purposes. Our analyses and findings sugges a possible basis on which o classify claims agains he firm s asses as liabiliies or equiy namely, on he basis of he claims effecs on common equiy risk and expeced reurn. Specifically, claims ha increase he risk of and expeced reurn on common equiy would be classified as liabiliies, and claims ha do no increase common equiy risk and expeced reurn would be classified as equiy. Alhough our resuls primarily have implicaions for classificaion of employee sock opions as deb or equiy, our findings also sugges ha disaggregaion wihin equiy can be informaive. Specifically, because he risk and expeced reurn characerisics of employee sock opions and common equiy differ, disaggregaing hese componens of equiy likely would provide useful informaion o invesors. 35

38 Appendix A Numerical Example This appendix offers a numerical example o illusrae he effecs of employee sock opion issuance on a firm s capial srucure and he accouning issues addressed in his sudy. To faciliae comparison wih Kirschenheier e al. (2004), we begin wih a simplified se of assumpions. In paricular, we consider an all-equiy firm creaed a he end of year zero by raising equiy. Proceeds of $ from he sale of 100 shares are invesed in producive asses earning a cerain afer-ax reurn of 10%. All available cash flow is reained and invesed. A he end of year one when he sock price is $1.10, he firm grans a-he-money opions in lieu of $9.00 of cash wages. The opions are exercised a he end of year hree. A he end of year four, he firm is liquidaed. Figure 1 shows financial saemens and key performance measures for hree presenaions of opions. In he firs panel of Figure 1, opions are presened as liabiliies. In he second panel of Figure 1, opions are presened as equiy claims agains he expeced value of asses, where he expeced value of asses includes he presen value of he srike price, and he value of he opion equiy claim equals he value of he opion holders undivided ineres in he firm s asses. 25 This presenaion grosses up he saemen of financial posiion by he srike price receivable and allows us o illusrae he valuaion mechanics of opions. The hird panel of Figure 1 is idenical o he second panel, excep ha he srike price receivable is need agains he opion equiy. Panel 3 is mos consisen wih curren GAAP Opion holders undivided ineres equals 32% of firm asses and fuure income calculaed as: 47.14/( ). 26 We ignore deferred axes because hey complicae he analysis wihou providing addiional insigh abou liabiliy/equiy classificaion of opion claims. Including deferred axes does no aler he example s conclusions. 36

39 In each panel of Figure 1, he value of common equiy a he end of each period equals he presen value of he liquidaion proceeds disribued o common equiy holders a ime T: MMMMMM = nn nn+mm 1 (1+ii) TT MMMMMM TT (A1) where n is he number of shares of common, m is he number of opion shares, and MVA T is he value of asses when he asses are liquidaed. 27 Based on he assumed facs, common equiy holders (opion holders) expec o receive 68% (32%) of he liquidaion value of asses in period four. The liquidaion value of asses includes he cash received from opion holders in period hree plus cumulaive reinvesed earnings. Figure 1 shows ha he value of asses is $ afer he opions are issued a he end of period one. The value of asses differs from he book value of asses in Panels 1 and 3 because he presen value of he srike price is no included in asses under he opions-asliabiliies approach or curren GAAP. In conras, he presen value of he srike price is included in asses in Panel 2, so he book value of asses equals he value of asses in each period. When opions are presened as liabiliies, as in Panel 1, opion financial expense is impued by muliplying he value of he opion gran by he expeced rae of reurn. This leads o lower ne income ha more accuraely reflecs he income aribuable o common equiy holders (Kirschenheier e al. 2004). However, impuing opion financial expense undersaes reurn on asses (ROA), which is assumed by he example o be a consan 10%. Based on he saemen of financial posiion, leverage is posiive, which oversaes he defaul risk of his unlevered firm. In conras, Panel 2 presens he opion in wo pars: he presen value of srike price is included in he book value of asses, and he value of he opion holders claims agains asses is included in equiy. Financial income is impued as he increase in he presen value of he srike 27 The value of he opion claims is deermined similarly, excep ha he fracion of proceeds equals m/(n + m). 37

40 price. However, consisen wih curren GAAP, increases in he value of opion equiy are no included in ne income. Panel 2 shows ha ROA is correcly repored a 10% and repored leverage is zero, consisen wih he example firm s fundamenals. Panel 3 reveals he same oucomes ROA of 10% and repored leverage of zero. In Figure 1, classifying opions as liabiliies appears o oversae he firm s leverage. However, heory also predics ha opion issuance decreases he risk of and expeced reurn on common equiy. These predicions canno be illusraed under cerainy because all cash flows earn he same risk-free rae of reurn (assumed o be 10% in he example). Therefore, we modify he example o include uncerainy. Specifically, in Figure 2 we mainain an expeced afer-ax reurn of 10% for he asses and se he sandard deviaion of equiy reurns equal o 44%. For an all-equiy firm, he reurn o, and variance of, equiy equal he reurn o, and variance of, asses. However, he issuance of coningen claims changes he capial srucure of he firm. We quanify he effecs of capial srucure changes by using a binomial pricing model o compue he expeced values and expeced raes of reurn of each equiy componen over he wo-year erm of he opions. Because uncerainy increases he value of opions, he firm mus issue only opions o compensae employees $9.00, raher han he opions ha he firm mus issue in he cerainy case. 28 This resuls in a oal srike price of $ In Figure 2, he erminal nodes of each binomial ree show expeced values of asses, equiy, and opions a he end of period hree. For ease of exposiion, he end of period hree is assumed o be he opion expiraion dae, and opion value and asse value are presened boh gross and ne of he srike price The number of opions equals $9.00 divided by he price of a single opion wih a srike price of $ The $9.00 opion price equals he $16.68 expeced presen value of he opion holders claim on he firm s gross asses, i.e., including he srike price, less he $7.68 expeced presen value of he $42.66 srike price. 38

41 The asse price ree in he upper lef-hand corner of Figure 2 shows he progression of asse values ha occurs when employees are paid cash insead of opions. This can be compared o he asse price ree in he upper righ-hand corner of Figure 2, which shows a higher expeced erminal value ($ compared o $133.10) when cash is conserved by paying compensaion wih opions (wih opions, asses are $ a he beginning of he erm, raher han $110.00, because he firm has conserved $9.00 in cash ha would have been paid in wages). Comparing he op wo asse rees in Figure 2 reveals ha he expeced reurn on asses of 10% is invarian o he issuance of opions. The asse price ree in he upper righ-hand corner also shows he effec of he srike price on he expeced value of asses, which increases o $ when he fuure expeced cash flow arising from opion exercise is included. Noe ha he $42.66 srike price is no included in he calculaion of he reurn of 10% because he srike price is a conribuion of capial raher han income. The opion price ree in he boom lef-hand corner of Figure 2 shows ha if he opions are exercised, opion holders receive ne value of $50.01, which is a oal wo-year reurn of 456% on heir $9.00 invesmen. However, compuing he opions reurn based only on he exercise value is misleading because he opions expire worhless 75% of he ime, in his example. The gross opions expeced erminal value of $23.17 incorporaes he poenial ha he opions expire worhless; hus, he opions expeced reurn a he dae of issuance is a more reasonable 18%. The value of he opion holders gross claim on oal asses is $16.68, which combines wih he equiy holders claim of $ o equal he expeced oal asse value of $ The equiy price ree in he boom righ-hand corner of Figure 2 reveals ha he value of equiy does no change when opions are issued: he value of equiy remains equal o he pre- 39

42 opion-issuance value of $ This is rue even hough he expeced presen value of asses increases. Comparing he asse price ree wih no opions (he 100% common equiy firm) o he equiy price ree wih opions (he mixed equiy firm) reveals ha he mixed equiy firm has a narrower range of poenial erminal common equiy values ($49.01 o $ compared o $45.30 o $267.10). The variance is lower because he opion holders $9.00 cash wage forfeiure provides insulaion agains downside oucomes, and because he opions absorb a fracion of upside oucomes. Consisen wih he lower variance, he expeced reurn on common equiy also is lower in he presence of opions (9% compared o 10%). 40

43 Appendix B Esimaing opion expeced reurn Daves and Ehrhard (2007) develops an approach o esimaing he variance of and expeced reurn on he componens of complex capial srucures. Daves and Ehrhard (2007) begins by showing ha he weighed average cos of capial, WACC, can be expressed as: WACC = r w + r 1 τ w (B1) Q Q D ( ) D where r Q and r D are he reurns on quasi-equiy and deb, and w Q and w D are he proporions of he firm financed wih quasi-equiy, Q, and deb, D. τ is he ax rae. Quasi-equiy includes common sock and claims ha migh become common sock, such as warrans. Deb includes only deb wihou an opion o conver ino common sock. When equiy includes employee sock opions, he required reurn on quasi-equiy is a weighed average of he required reurns on levered common equiy, r LCE, and he opions, r ω : LCE W rq = rlce + rω (B2) LCE + W LCE + W LCE is he value of levered common equiy and W is he value of employee sock opions ousanding. r LCE and r ω are he required raes of reurn on common equiy and he opions, each of which is subjec o ousanding deb. The oal value of he firm is he sum of he values of deb, levered common equiy, and he opions. Empirically, equaions (B1) and (B2) are rarely esimable because neiher r Q nor r ω is observable. By assuming ha quasi-equiy, which is equal o W + LCE, follows a Gauss-Weiner process, Daves and Ehrhard (2007) shows ha he value of he opions is given by: ωω = nn nn+mm SS NN(dd 1 ) XXee rrrr (TT ) NN(dd 2 ) (B3) 41

44 where dd 1 = llll (SS /XX)+ rrrr +σσ QQ 2 /2 (TT ) σσ QQ TT, dd 2 = dd 1 σσ QQ TT 1/2, and SS = SSSS qq(tt ) + mmmm/nn. S is he price of a common share, n is he number of common shares ousanding, m is he number of opions each converible ino one common share, q is he coninuous dividend, rf is he risk-free rae of reurn, and N( ) is he cumulaive normal disribuion funcion. Esimaion of equaion (B3) requires an esimae of σ Q, which is given by equaion (B4). σ Q q( T ) * n + mωs ne N ( d 1 ) = σs S, where ω S = σ S S ns + mω (B4) n + m 1 N ( d1) ( ) Equaions (B3) and (B4) can be solved numerically for he opion price, ω, and he parial derivaive of he opion price wih respec o he sock price, ω S, which can hen be used o solve for he required reurn on levered common equiy, rlce, using equaion (B5). ns + msωs mω msωs rq = rlce + rf (B5) ns + mω ns + mω The required reurn on he opion in erms of r LCE is given by equaion (B6). rr ωω = rrrr + (rr LLLLLL rrrr)ωω SS SS ωω (B6) From his sysem of equaions, Daves and Ehrhard (2007) shows ha issuing warrans does no change he weighed average cos of capial. However, i decreases he required reurn on common equiy. To see his, use equaion (B5) o compue r LCE r Q : rr LLLLLL rr QQ = (rr QQ rrrr) mmmm +mmmm ωω SS nnnn +mmmm ωω SS 0 (B7) The firs erm is negaive because he reurn on risky asses is greaer han he risk-free rae. The second erm is posiive because S > ω S > ω. Thus, issuing warrans lowers he required reurn on equiy. In addiion o decreasing he required reurn, issuing warrans also decreases he volailiy of equiy because equaion (5) implies ha σ Q < σ S. 42

45 References Aboody, D Discussion of Which Approach o Accouning for Employee Sock Opions Bes Reflecs Marke Pricing? Review of Accouning Sudies 11: Aboody, D., M. E. Barh, and R. Kasznik Do Firms Undersae Sock Opion-based Compensaion Expense Disclosed Under SFAS 123? Review of Accouning Sudies 11: Ball, R., G. Sadka, and R. Sadka Aggregae Earnings and Asse Prices. Journal of Accouning Research 47(5): Balsam, S Exending he Mehod of Accouning for Sock Appreciaion Righs o Employee Sock Opions. Accouning Horizons 8: Barh, M. E., W. H. Beaver, and W. R. Landsman Relaive Valuaion Roles of Equiy Book Value and Ne Income as a Funcion of Financial Healh. Journal of Accouning & Economics (25): Barh, M. E., L. D. Hodder, and S. R. Subben Fair Value Accouning for Liabiliies and Own Credi Risk. The Accouning Review 83(3): Barh, M. E., Y. Konchichki, and W. R. Landsman Cos of Capial and Earnings Transparency. Working paper, Sanford Universiy. Barov, E., P. Mohanram, and D. Nissim Managerial Discreion and he Economic Deerminans of he Disclosed Volailiy Parameer for Valuing ESOs. Review of Accouning Sudies 12(1): Beaver, W., P. Keler, and M. Scholes The Associaion beween Marke-deermined and Accouning-deermined Risk Measures. The Accouning Review: Black, F, and M. Scholes The Pricing of Opions and Corporae Liabiliies. The Journal of Poliical Economy 81(3): 637 Boosan, C. and M. Plumlee Assessing Alernaive Proxies for he Expeced Risk Premium. The Accouning Review 80(1): Carpener, J Does Opion Compensaion Increase Managerial Risk Appeie? The Journal of Finance 55(5): Clark, M.W Eniy Theory, Modern Capial Srucure Theory, and he Disincion beween Deb and Equiy. Accouning Horizons 7(3): Coles, J., N. Daniel, and L. Naveen Managerial Incenives and Risk-aking. Journal of Financial Economics 79:

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47 Hillegeis, S. A., E. K. Keaing, D. P. Cram, and K. G. Lundsed Assessing he Probabiliy of Bankrupcy. Review of Accouning Sudies (9): Hull, J. and A. Whie Accouning for Employee Sock Opions. Working paper, Universiy of Torono. hp:// ions.pdf Ingersoll, J A Coningen-Claims Valuaion of Converible Securiies. Journal of Financial Economics 4(3): Jegadeesh, N., and S. Timan Reurns o Buying Winners and Selling Losers: Implicaions for Sock Marke Efficiency. Journal of Finance 48: Kirschenheier, M., R. Mahur, and J. Thomas Accouning for Employee Sock Opions. Accouning Horizons 18(2): Koreweg, A Financial Leverage and Expeced Sock Reurns: Evidence from Pure Exchange Offers. Working paper, Sanford Universiy. Lamber, R. A., D. F. Larcker, and R. E. Verrecchia Porfolio Consideraions in Valuing Execuive Compensaion, Journal of Accouning Research 29(1): Landsman, W, K. Peasnell, P. Pope, and S. Yeh Which Approach o Accouning for Employee Sock Opions Bes Reflecs Marke Pricing? Review of Accouning Sudies 11: Li, F., and F. Wong Employee Sock Opions, Equiy Valuaion, and he Valuaion of Opion Grans Using a Warran-Pricing Model. Journal of Accouning Research 43(1): Mayhew, S Implied Volailiy. Financial Analyss Journal 51(4): Maines, L., E. Barov, A. Beay, and C. Boosan Evaluaion of he IASB's Proposed Accouning and Disclosure Requiremens for Share-Based Paymen. Accouning Horizons 18(1): Meron, R. C On he Pricing of Corporae Deb: The Risk Srucure of Ineres Raes. The Journal of Finance 29: Modigliani, F., and M. H. Miller The Cos of Equiy, Corporae Finance, and he Theory of Invesmen. American Economic Review 48(3): Corporae Income Taxes and he Cos of Capial: A Correcion. American Economic Review 53(3):

48 Noreen, E., and M. Wolfson Equilibrium Warran Pricing Models and Accouning for Execuive Sock Opions. Journal of Accouning Research 19(2): Ohlson, J., and S. Penman Deb vs. Equiy: Accouning for Claims Coningen on Firms Common Sock Performance wih Paricular Aenion o Employee Compensaion Opions. Working Paper, Columbia Business School. Paon, W Accouning Theory. New York: The Roland Press. Pasor, L., and P. Veronesi Sock Valuaion and Learning abou Profiabiliy. The Journal of Finance 58(5): Penman S., S. Richardson, and I. Tuna The Book-o-Price Effec in Sock Reurns: Accouning for Leverage. Journal of Accouning Research (45)2: Rajgopal, S., and T. Shevlin Empirical Evidence on he Relaion beween Sock Opion Compensaion and Risk Taking. Journal of Accouning and Economics 33: Robichek, K., and S. Myers Problems in he Theory of Opimal Capial Srucure. Journal of Financial and Quaniaive Analysis 1(2): Rubinsein, M. E A Mean-Variance Synhesis of Corporae Financial Theory. The Journal of Finance 28(1): Sacho, Z., and J. Oberholser Should he IASB Consider Exercise Dae Accouning for Ousanding Employee Share Opions? Mediari Accounancy Research 13(2): Schulz, G., and S. Traumann Robusness of opion-like warran valuaion. Journal of Banking & Finance 18(5): Sprague, C The Philosophy of Accouns. New York: Published by he Auhor (1908). Terando, W., W. Shaw, and D. Smih Valuaion and Classificaion of Company Issued Cash and Share-pus. Review of Quaniaive Finance and Accouning 29(3): Ukhov, A Warran Pricing using Observable Variables. Journal of Financial Research 27(3): Williams, M., and R. Rao CEO Sock Opions and Equiy Risk Incenives. Journal of Business Finance & Accouning 33(1):

49 Figure 1: Three Presenaions of Opions Panel 2: Opions as Equiy Claims on Panel 1: Opions as Liabiliies Larger Asse Pool Period Saemen of Financial Posiion Producive Asses Oher Asses Toal Asses Sock Opion Liabiliy Owner's Equiy Opions Conribued Capial Reained Earnings Toal Equiy Toal Liabiliies and Equiy Income Saemen Operaing Income Opion Expense Opion Financial Expense Ne Income Operaing Cash Flows Cash from ne sales Impued Cash Flows Opions Ne Operaing Cash Flows Price Daa Value of Opion Claims (32%) Value of Common Claims (68%) Value of Asses Financial Measures Reurn on Asses 10% 9% 9% 10% 10% 10% 10% 10% Reurn on Equiy 10% 10% 10% 10% 10% 10% 10% 10% Leverage (Deb/Asses) 8% 8% 0% 0% 0% 0% 0% 0% 47

50 Figure 1 (Coninued): Three Presenaions of Opions Panel 3: Srike Price Receivable Need Agains Opion Equiy Period Saemen of Financial Posiion Producive Asses Oher Asses Toal Asses Sock Opion Liabiliy Owner's Equiy Opions Conribued Capial Reained Earnings Toal Equiy Toal Liabiliies and Equiy Income Saemen Operaing Income Opion Expense 9.00 Opion Financial Expense Ne Income Operaing Cash Flows Cash from ne sales Impued Cash Flows Opions Ne Operaing Cash Flows Price Daa Value of Opion Claims (32%) Value of Common Claims (68%) Value of Asses Financial Measures Reurn on Asses 10% 10% 10% 10% Reurn on Equiy 10% 10% 10% 10% Leverage (Deb/Asses) 0% 0% 0% 0% 0% 48

51 Figure 2: Effec of Opions on Expeced Reurn Asse Price Tree wih Opions Asse Price Tree No Opions Includes (*Excludes) Srike Price * * * Expeced Value * * * Expeced Rae of Reurn 10% 10% 10% 10% Opion Price Tree Includes (*Excludes) Srike Price Equiy Price Tree wih Opions * * * Expeced Value Expeced Rae of Reurn 18% 18% 9% 9% The binomial rees show simulaed price pahs for asses, opions, and equiy for wo periods. The expeced value a each node is he average of poenial oucomes. The expeced rae of reurn is equal o ending expeced value/beginning expeced value minus 1. Simulaion parameers are as follows: value of asses a gran dae = $110; value of opions on gran dae = $9; number of opions graned is 38.78; srike price = $1.10; expeced rae of reurn on asses = 10%;1 + risk free rae of reurn (rf) = 1.05%; sandard deviaion of asses = 44.4%; probabiliy of upick = 50%; value on upick (u) = 155.5%; and value on downick (d) = 64.2%. The risk-neural probabiliy of an upick (p) is compued as (rf d)/(u d) and is equal o a each node. Leing U = he value on an upick and D = he value on a downick, he value a each node is compued as (pu)/rf + (1 p)d/rf. 49

52 Table 1: Descripive Saisics Panel A: Disribuional Saisics N Mean Sd. Dev. Q1 Median Q3 EQUITYVOL 26, IMPLIEDVOL 12, ECC 26, OPTIONS 35, LEVERAGE 33, CREDITRISK 30, SIZE 34, EARN 35, CHANGE_EARN 34, GROWTH 15, PROPENSITY 25, CHANGE_RD 30, REPRICE 10, AVG_TERM 26,

53 Table 1 (coninued): Descripive Saisics Panel B: Pearson (Spearman) Correlaions Above (Below) Diagonal EQUITYVOL IMPLIEDVOL ECC OPTIONS LEVERAGE CREDITRISK SIZE EARN CHANGE_EARN GROWTH PROPENSITY CHANGE_RD REPRICE AVG_TERM EQUITYVOL is sandard deviaion of monhly sock reurns over subsequen year; IMPLIEDVOL is equiy volailiy implied by raded opions a year-end; ECC is equiy cos of capial (Barh, Konchichki, and Landsman 2010); OPTIONS is employee sock opions ousanding (ESO) o he sum of shares and ESO; LEVERAGE is he raio of he book value of deb o he sum of book value of deb plus he marke value of equiy; CREDITRISK is esimaed credi risk from bond raing predicion model (Barh, Beaver, and Landsman 1998); EARN is annual income before exraordinary iems(excluding ESO expense), divided by oal asses; CHANGE_EARN is annual change in EARN; GROWTH is analyss' consensus long-erm growh forecas, a end of year; SIZE is log of marke value of equiy; PROPENSITY is he expeced value of OPTIONS, excluding segmen daa (Core and Guay 2001); CHANGE_RD is one-year-ahead change in R&D expendiures; REPRICE is an indicaor variable se equal o 1 if he firm disclosed repricing of ESOs for a leas one execuive during he fiscal year; AVG_TERM is an indicaor variable se equal o 1 if he weighed average erm of ESOs is above he median for he sample. 51

54 Table 2: Regression of Equiy Risk on Opions RISK + 1 = β + β OPTIONS 0 + β CHANGE β LEVERAGE + β CREDITRISK + β SIZE _ EARN + β 7GROWTH + β 8PROPENSITY + β 9 + β EARN 5 CHANGE _ RD + ε Panel A: RISK = Realized Equiy Volailiy, EQUITYVOL Pred. Coef. -saisic Coef. -saisic Coef. -saisic Coef. -saisic OPTIONS LEVERAGE CREDITRISK SIZE EARN CHANGE_EARN? GROWTH PROPENSITY CHANGE_RD N Obs. 22,374 12,883 21,075 20,429 R squared 26.1% 25.5% 25.1% 26.3% 52

55 Table 2 (coninued): Regression of Equiy Risk on Opions RISK + 1 = β + β OPTIONS 0 + β CHANGE β LEVERAGE + β CREDITRISK + β SIZE _ EARN + β 7GROWTH + β 8PROPENSITY + β 9 + β EARN 5 CHANGE _ RD + ε Panel B: RISK = Implied Volailiy, IMPLIEDVOL Pred. Coef. -saisic Coef. -saisic Coef. -saisic Coef. -saisic OPTIONS LEVERAGE CREDITRISK SIZE EARN CHANGE_EARN? GROWTH PROPENSITY CHANGE_RD N Obs. 11,329 9,262 10,971 10,292 R squared 38.7% 36.9% 29.5% 38.6% 53

56 Table 2 (coninued): Regression of Equiy Risk on Opions RISK + 1 = β + β OPTIONS 0 + β CHANGE β LEVERAGE + β CREDITRISK + β SIZE _ EARN + β 7GROWTH + β 8PROPENSITY + β 9 + β EARN 5 CHANGE _ RD + ε Panel C: Opion Aribues Repricing and Term o Mauriy RISK = EQUITYVOL 54 RISK = IMPLIEDVOL Repricing Longer Term Repricing Longer Term Pred. Coef. -saisic Coef. -saisic Coef. -saisic Coef. -saisic OPTIONS OPTIONS REPRICE OPTIONS AVG_TERM REPRICE? AVG_TERM? LEVERAGE CREDITRISK SIZE EARN CHANGE_EARN? N Obs. 8,641 17,942 6,987 9,355 R squared 26.1% 27.1% 33.8% 40.0%

57 EQUITYVOL is sandard deviaion of monhly sock reurns over subsequen year; IMPLIEDVOL is equiy volailiy implied by raded opions; ECC is equiy cos of capial (Barh, Konchichki, and Landsman 2010); OPTIONS is employee sock opions ousanding (ESO) o he sum of shares and ESO; LEVERAGE is he raio of he book value of deb o he sum of book value of deb plus he marke value of equiy; CREDITRISK is esimaed credi risk from bond raing predicion model (Barh, Beaver, and Landsman 1998); EARN is annual income before exraordinary iems, divided by oal asses; CHANGE_EARN is annual change in EARN; GROWTH is analyss consensus long-erm growh forecas, a end of year; SIZE is log of marke value of equiy; PROPENSITY is he expeced value of OPTIONS, excluding segmen daa (Core and Guay 2001); CHANGE_RD is one-year-ahead change in R&D expendiures; REPRICE is an indicaor variable se equal o 1 if he firm disclosed repricing of ESOs for a leas one execuive during he fiscal year; AVG_TERM is an indicaor variable se equal o 1 if he weighed average erm of ESOs is above he median for he sample. Regression sandard errors are clusered by indusry and year. 55

58 Table 3: Regression of Equiy Cos of Capial on Opions ECC = β + β OPTIONS + β LEVERAGE + β SIZE + β BM + β BETA 0 + β MOM β GROWTH + β DISPERSION + ε Pred. Coef. -saisic Coef. -saisic OPTIONS LEVERAGE SIZE BM BETA MOM GROWTH DISPERSION N Obs. 25,057 11,036 R squared 8.6% 10.8% ECC is equiy cos of capial (Barh, Konchichki, and Landsman 2010); OPTIONS is employee sock opions ousanding (ESO) o he sum of shares and ESO; LEVERAGE is he raio of he book value of deb o he sum of book value of deb plus he marke value of equiy; SIZE is he naural log of marke value of equiy; BM is book value of equiy divided by marke value of equiy; BETA is CAPM bea esimaed on monhly reurns over rolling 5-year windows; MOM is raw sock reurn over he firs 10 monhs of he year; GROWTH is analyss consensus long-erm growh forecas, a end of year; DISPERSION is he naural log of he sandard deviaion of analyss earnings forecass a end of year. 56

59 Table 4: Values and Expeced Reurn on Opions Panel A: Disribuional Saisics N Mean Sd. Dev. Q1 Median Q3 B-S Value 24, D-E Value 24, RET_OPT 19, ECC LEVERAGE BETA EQUITYVOL RET_OPT ECC 26, , , , , Panel B: Pearson Correlaions B-S Value D-E Value RET_OPT ECC LEVERAGE BETA EQUITYVOL B-S value is he Black-Scholes opion value esimaed consisen wih Landsman e al. (2006). D-E value is he opion value esimaed using he mehod of Daves and Ehrhard (2007), scaled by marke value of equiy. RET-OPT is expeced reurn on opions (Daves and Ehrhard 2007); LEVERAGE is he raio of he book value of deb o he sum of book value of deb plus he marke value of equiy; BETA is CAPM bea esimaed on monhly reurns over rolling 5-year windows; EQUITYVOL is sandard deviaion of monhly sock reurns over subsequen year. 57

60 Table 5: Sensiiviy of Opion, Common Equiy and Deb Values o Changes in Asse Value Panel A: Median Value Changes by Quinile of Disance o Defaul ΔMVE / ΔMVD / ΔMVO / Quinile ΔMVA ΔMVA ΔMVA 1 Small Disance o Defaul Large Disance o Defaul Panel B: Regression of Value Change on Disance o Defaul 0 1 MVX / MVA = β + β DISTANCE + ε Pred. Coef. -saisic MVE / MVA MVD / MVA MVO / MVA Panel A presens he sensiiviies of equiy, deb, and opion values o changes in asse value across various disances o defaul. A small (large) disance o defaul means ha defaul is more (less) likely. ΔMVE is he change in marke value of common equiy; ΔMVA is he esimaed change in ne asse value (excl. deb), from he Meron (1974) model; ΔMVD is he esimaed change in deb value, from he Meron (1974) model. For esimaion procedures for ΔMVA and ΔMVD see Barh, Hodder, and Subben (2008). MVO is he esimaed value of ESOs ousanding (Landsman e al. 2006); DISTANCE is disance o defaul measured as MVA book value of deb, scaled by MVA. 58