THE UTILITY-BASED VALUATION AND COST OF EXECUTIVE STOCK OPTIONS IN A BINOMIAL FRAMEWORK: ISSUES AND METHODOLOGIES

Abstract

Options are among the most important forms of compensation and incentive structuring. Standard option pricing theory provides guidelines but not a conclusive prescription of how to value executive stock options. Academic research on this subject has gone in several related but distinct directions. This paper examines one thread of this research stream: binomial models based on expected utility. We start by illustrating the procedures for estimating executive option values using expected utility analysis in a binomial framework. Using a common set of inputs based on empirical data, we compare option values and company costs based on differences in inputs and assumptions. Our findings identify variables that are important and others with relatively minor impact. We also examine the effect of dividends on executive stock options values, a topic that has been largely ignored to date. We present the argument for why the economic cost of an option equals its economic value, which contrasts with standard accounting procedures. This conflict between economics and accounting, while not new, can explain why corporations are so uncomfortable with new accounting rules for expensing executive stock options.