Financial Economics Issues - Assignment Example

Question A stock option plan is a strategic compensation plan utilized by many organizations that are unable to pay high salaries to retain old personnel and attract new recruits. The stock option plan allow its holder to purchase common stocks of the company they work for at a predetermine exercise option price which is typically the market price of the stock at the time of the issuance. Stock option plans provide companies with the flexibility to award stock options to employees, officers, and consultants which permits these stakeholders to share in the company’s success (Allbusiness). Over time the option can gain a lot of value if the price of the stock rises since the employee has the right to purchase the stocks at the predetermined price. Since the objective for the employee is to gain the maximum monetary benefit possible as a beneficiary of a stock option plan I would encourage the company to implement financial and investment strategies that will increase the value of the firm. In order to learn the best strategy to optimize the value of the stock option plan we must evaluate the potential effects of the company choosing increased dividend payout strategy vs. stock repurchase program. The dividend payout policy of a firm refers to the decision regarding the magnitude of the dividend payout which is the percentage of earnings paid to the stockholders in the form of dividends (Referenceforbusiness). The owner of a company’s common stock will always prefer to have the highest dividend payout possible. One of the main reasons people like dividends so much is because they are obtaining an immediate financial return instead of waiting for the sale of the stock to achieve a capital gain. In order to better understand the effect of dividend we must recognize the existence of retained earnings. At the end an accounting period when profits are determine the board of director can either declare dividends or kept the profits in the form of retained earnings. When money is not distributed and it is kept as retained earnings the company can utilize these funds to make the business grow. If a company is able to invest its money wisely in high yield projects, the firm can achieve internal grow that will raise the market value of the company. During bad financial times such as the current global recession it is common for companies to reduce their payout of cash dividends in order to maintain its liquidity and to keep its cash balance as high as possible (Bigda). A sector that has been horribly as far as reduction in payout policy recently is the financial sector which includes the banking industry. There is lots of contracting information relating to the actual affects dividend have on share price, but evidence has shown that companies that pay higher dividends over time tend to go up in value more than those that do not (Li & Zhao). One of the problems associated with the payout of dividends and the reaction of the participants of the markets is that when a company consistently pays out dividends it creates an expectation among the shareholders. This expectation becomes a problem because if a firm for any reason decides to lower its dividend payout ratio in particular period, the move becomes a warning sign for investor that something is wrong when reality nothing might be wrong. If a company suddenly decides to lower the dividends it must be prepared for a decline in the market value of its stock. Another common belief among the investor community is that a lower dividend payout ratio will lead to a higher growth in earnings in the future (Low Payout Ratios Lead to Future Dividend Growers). A second strategy that company can utilized increase its shareholder value without the utilization of dividends is to incur in a stock repurchase program. A stock repurchase program is an action taken by the board of directors that authorizes corporate management to go to the open market and repurchase its own shares up to a specified limit within a specified period of time (Answers). The implementation of a stock repurchase program tends to have positive effects in the value of a common stock because this alternative reduces the amount of outstanding stocks available, increases the earnings per share, and allows shareholders to receive a premium purchase typically above the market value from the corporation. Three principles associated with the implementation of stock repurchase plan are: Overall Growth is not as important as growth in terms of earnings per share If a company reduces the amount of shares outstanding, the remaining shares become more valuable and account for a greater proportion of the overall equity of the firm A stock repurchase plan becomes counterproductive if the buying firm ends up paying too much for its common stocks (About). As a new beneficiary of a stock option plan I have to think in terms of what is best for my option plan. Dividend payout policies that encourage higher cash dividends are good because they allow the investor to earn an extra return independent of the movement in the market price of the shares. Many people might think that this is the best alternative since it provides a tangible cash disbursement, but I believe that high dividend payout ratio may be detrimental to the long term wealth accumulation of a company. The alternative of choosing a stock repurchase program provides the greatest benefit. The option automatically decreases the amount of shares outstanding, which means that the market capitalization of the equity of the firm has to spread over a small amount of shareholders, therefore increase the overall value. Another advantage of the alternative is that it enables the company to put away some money for the future in the form of treasure stocks. The return on equity of the firm as well as its earnings per share are going to be higher which means management is meeting its goal of maximizing shareholders wealth. Question 2 A call option is a financial instrument that gives the holder the right to buy a lot of shares of a particular common stock at a specified price any time prior to a specified expiration date (Jones, 1996). Call options are considered future instruments that allow investor to speculate on the future price of particular common stock or commodity. A person can make money from a call option only if the option is exercise prior to expiration date. For example if an investor has a call option to buy at $60 and the current price of the stock is $80, then it would be wise to exercise the call option in order to receive a $20 per share gain. If the price of the stock were to go down, then the best alternative is to let the option expire and accept the losses associated with the purchase of the call option. There exist two types of call options. These two call option alternatives are ex-dividend call option and with dividend call options. We are going to evaluate which alternative is better. The fundamental difference between an ex-dividend call option and a with dividend call option is that the with dividend allows the buyer to obtain the common stock when the option is exercised as well as any dividends that were pay while the investor owned the call option. In an ex-dividend call option arrangement the investor only has the right to receive the common stocks if the person exercises the option. Since an with dividend call option offers greater benefits these types of option s are more expensive than ex-dividend call options. Call option in general are a risky proposition, thus an investor has to decide how aggressive they want to be. A person dealing in with dividend call options is paying a higher price for the possibility of a higher reward. Higher rewards naturally mean higher risks. Ex-dividend call options are cheaper and still provide great financial rewards when the investor forecast the price movement correctly. For me ex-dividend call option are a better proposition due to the lower costs associated with their purchase. The added cost associated in with-dividends arrangements are not really worth the risk in comparison with an ex-dividend call option. Works Cited Page About.com. 2009. “Share repurchase program.” 25 August 2009. Allbusiness.com. 2..9. “Stock Option Plan.” 25 August 2009. Answers.com. 2009. “Stock Repurchase Plan.” 25 August 2009. Bidga, C. February 2009. “Reap the Most Income at the at the least risk.” Money, 38.2. Jones, C. 1996. Investments: Analysis and Management (5th ed.). New York: John Wiley & Sons. Li, K.., Zhao, X. Winter 2008. “Asymmetric Information and Dividend Policy.” Financial Management 37.4 Low Payout Ratio Points to Future Dividend Growers. June 2008. DRIP Investor 17.6. Referenceforbusiness.com (2007). “Dividend Policy.” 25 August 2009. Read More