Reference no: EM131190429

Among many tools used in practice to alleviate this problem, is the use of stock options. Now consider two alternative stock option schemes: Scheme one (Traditional): Let X denote the closing stock price at the time the stock option is granted. The stock option has 10 years until it expires worthless unless exercised before the expiration date. The first three years of the 10-year life of the option is known as the vesting period, and the options cannot be exercised during the vesting period. Once the vesting period is over, and the options are vested, hence exercisable, the employee has the right to exercise the option anytime he/she wants by paying $X per share. Let S(t) denote the stock price at the time of option exercise. Of course we would expect S(t)>>X. For convenience, we will not ask the employee to pay actual money, instead for each option he will be granted (S(t) – X)/S(t) = (1 – X/S(t)) shares for free. Scheme two (Wacky): Let X denote the closing stock price at the time the stock option is granted. The stock option has 10 years until it expires worthless unless exercised before the expiration date. The first three years of the 10-year life of the option is known as the vesting period, and the options cannot be exercised during the vesting period. Let S(t) denote the stock price at the time of option exercise, and let S(v) denote the average daily price of the stock during the 3-years of vesting period. Once the vesting period is over, the employee has the option to exercise any time until expiration. Upon exercise, for each option the employee has, he will be given 0.5 (S(t) + S(v) – X) / S(t) = 0.5 + (S(v) – X)/S(t) shares for free. You are the Chairman of the Board of Directors, and you need to choose one of these schemes. Which one would you choose. Please defend your answer using logical and economic arguments.