EXECUTIVE STOCK OPTIONS: A FIRM VALUE APPROACH

Abstract

Executive stock options are an important component of executive compensation and the topic is of interest to both practitioners and academics. The vigorous debate on whether these options should be treated as an expense is subsiding but discussion continues on how these instruments should be valued in order to expense them. In this paper, executive stock options are viewed as contingent claims on a firm's assets and we formalize this through the concept of an augmented balance sheet. This means that the total market value of the firm's assets is equal to the market value of its traded securities plus the market value of its stock options. This approach leads to two valuation formulae for these options: one in terms of the firm's stock price and the other in terms of firm value. We explore the connections between these two approaches and derive explicit valuation formulae under certain assumptions.