Elle Forest: Valuing Stock Options in a Compensation Package

Elle Forest, a second-year MBA student at the Rotman School of Management, was super
excited about her upcoming June 2015 graduation. It was only November; however, she had
listened faithfully to her career coach, and she has done an amazing job networking all year
with potential employers, but she really didnt want any of those investment banking or
consulting jobs. Those coffee chats at the Starbucks on Bloor Street really were worth all the
time and effort because she had just received a job offer to join her favorite company of all
time, Tiffany & Company. She was already dreaming of more little turquoise boxes on her
bookshelf, where she already had quite a nice collection. In 2000, the Tiffany & Company
Foundation was established to fund grants for non-profit organizations in the areas of the arts
and education. Elle had recently been offered the position of Vice-President, Public Relations,
for the Foundation.
Just after her upcoming graduation, Elle would be getting married in the Hamptons and
moving to New York to a gorgeous apartment on the Upper East Side. What a find it was! Her
fianc, Chip, was about to graduate from Yale Law School and would start his job as an
associate at Cravath Swaine & Moore LLP in New York.
Elle had tentatively accepted the Tiffany job and was in final negotiations with them about the
financial structure of the deal. They had offered her several choices, some of which included
executive stock options. During a phone call with Chip the other night, Elle had discussed the
total compensation package. She was a bit confused about the subtleties of the offer.
Here follows the conversation that Elle and Chip had about the offer and options for her
compensation package.
Chip: I am so happy for you honey! This offer is amazing! I know that it is your favorite
company. Just think about all those little blue boxes!
Elle: Thank you, darling. I am trying to decide what to do. I have been offered an annual
salary of $85,000, but that really just isnt enough to pay the rent. The HR lady also said that I
could choose between an additional $20,000 signing bonus in cash or company stock options
that expire and vest after 2 years and after 4 years, respectively. I just dont know what to do.
Chip: Why dont you look at your class notes from your Finance classes? I bet your
professors might have told you how to compute the value of these options. You always said
that they gave you really detailed slides for every class. Do you still have access to a
Bloomberg machine?
Elle: Thats a great idea. I am super organized. My binders are right here, all color-coded and
organized by term. Ok, let me see. The proposed contract says that I will be granted 1,000 at-

the-money options to buy one share of Tiffany & Co. stock on my second anniversary with the
company and 1,000 options to buy one share of stock on my fourth anniversary with the
company. Yesterday, the stock closed at $107.92. I think this offer seems really great, but I cant
decide whether to take the $20,000 cash or the stock options. The money up front would help
us hire that amazing decorator to redo the new apartment, and I could spend a little on some
new shoes and bags.
Chip: What are the tax implications of these two situations? What will be your marginal tax
rate? How about your capital gains tax rate?
Elle: Oh, right. Sorry. I was dreaming of that pair of Louboutins. My marginal tax rate will be
about 32%, and my capital gains tax rate will be 16%. I am so confused. Which choice is
better?
Chip: Keep in mind, Elle, that I might get transferred to my firms offices in Sydney. If we
move away from New York in the first 4 years, will you lose the benefit of these options?
Elle: Yes, the two option packages are worthless if I am not working at the company at the
end of 2 years and at the end of 4 years, respectively.
Chip: Hmmm. Maybe you should just take the cash then, if there is a chance that these
options might be worthless. However, keep in mind that I have a nice salary also, we are not
going to starve in either case.
Elle: OK. Thanks for the advice, honey.
Chip: Im sure that you will make the right decision. I cant wait to see you next weekend.
Elle: Goodnight. Kiss. Kiss.
Elle got out her iPad and looked up the recent price chart and dividend yield of Tiffany stock
(Exhibit 1). She could not find valuations for the options she needed, but she did find quotes of
some related options traded on an options exchange (Exhibit 2). She also found information
about the historical volatility of Tiffanys stock (Exhibit 3) and the Treasury spot rates (Exhibit 4).
As she washed her face, she thought about the problem. Tomorrow, she would try to figure
out the value of the stock options. She would also need to talk to Chip more about whether
they really wanted to live in New York forever. He had been talking lately about moving to
Australia. Chip had always dreamed of living in Sydney, and his law firm had offices there. If
they wanted to live in New York for a few years, would the cash bonus or the stock options be
the right choice? What if they moved to Sydney? Elle pondered her choices. She fell asleep
dreaming of those little blue boxes and beautiful shoes.

____________________________________________________________________________________
Exhibit 1: Stock Price and Dividend Yield of Tiffany & Company Common Stock

Exhibit 2: Listed Tiffany Options Quotations as of November 28, 2014*

*Note that the strike prices are shown in the three digits preceding -E: $100, $105, $110, and $115.
Exhibit 3: Volatility of Returns on Tiffany Stock, January 1, 2005-November 28, 2015*

*Annualized standard deviation of daily returns based on rolling 90-day window

Exhibit 4: U.S. Treasury Spot Rates and Forward Rates as of November 28, 2014

Your assignment: Determine the value of each offer, and decide which choice she should
make: take the options, or accept the $20,000 signing bonus. Your explanation should include
the Excel calculations that determine the value of her 2-year and 4-year option packages. You
should write a 1-page memo to Elle with calculations in simple language and show your clear
reasoning as to why she should choose one compensation package instead of the other one.
Address the following questions in your write-up:
1. Describe, in general terms, Elles ESO (executive stock option) decision. You should
recognize this as a NPV problem that compares alternative future cash flows. What is
the NPV of the cash alternative?
2. Describe Elles ESOs in terms of the parameters that would be put into an option pricing
model. Which option pricing model is appropriate? Which parameters are known with
certainty? What uncertainties does she have about parameters and probabilities?
3. In particular, evaluate the question of Tiffanys stock price volatility. Using the
BlackScholeCalculator.xls spreadsheet on the portal, determine what volatility the
market is using to price the publicly trading Tiffany options. For what periods of time
are these volatilities implied? In your judgment, what value for volatility should be
used to value the ESOs?
4. What is your estimate of the value of Elles ESO package? If you were to take the
options and gamble on the stock price going forward, what percentage of the time do
you think you would make more than the value Black-Scholes formula calculates?
5. What would you do if you were Elle? Why?