CEP Valuation & Financial Analysis 2 — Questions and Answers
Question 1: Under ASC 718, which method is most commonly used to estimate the fair value of employee stock options?
- Binomial lattice model
- Black-Scholes-Merton model (Correct answer)
- Monte Carlo simulation
- Intrinsic value method
Correct answer: Black-Scholes-Merton model
The Black-Scholes-Merton model is the most widely used method for estimating fair value of employee stock options under ASC 718.
Question 2: Which input to the Black-Scholes-Merton model is considered the most subjective and most challenging to estimate for employee stock options?
- Risk-free interest rate
- Dividend yield
- Expected term (Correct answer)
- Stock price
Correct answer: Expected term
Expected term is the most subjective input because it must account for employee exercise behavior, which differs from a rational market participant.
Question 3: A company's stock has a current price of $50. A call option with a $45 exercise price has an intrinsic value of:
- $0
- $5 (Correct answer)
- $45
- $50
Correct answer: $5
Intrinsic value for a call option is the excess of stock price over exercise price: $50 - $45 = $5.
Question 4: Which of the following best describes 'time value' of an option?
- The present value of expected future dividends
- The difference between fair value and intrinsic value (Correct answer)
- The discounted exercise price of the option
- The cost of carry for the underlying stock
Correct answer: The difference between fair value and intrinsic value
Time value equals total option fair value minus intrinsic value, reflecting the probability that additional value may be gained before expiration.
Question 5: The 'simplified method' for estimating expected term of stock options, as permitted by SEC SAB 107, calculates expected term as:
- The contractual term divided by two
- The average of the vesting period and contractual term (Correct answer)
- The median holding period based on peer data
- The expected volatility multiplied by contractual term
Correct answer: The average of the vesting period and contractual term
The simplified method computes expected term as the average of the option's vesting period and full contractual term.
Question 6: Which of the following would INCREASE the fair value of an employee stock option, all else equal?
- Increase in expected dividend yield
- Decrease in expected volatility
- Decrease in risk-free interest rate
- Increase in expected term (Correct answer)
Correct answer: Increase in expected term
A longer expected term increases fair value because the option has more time to benefit from favorable stock price movements.
Question 7: For a company with no history of paying dividends that is considering initiating dividends, what is the most appropriate dividend yield assumption for option valuation?
- Zero, since no dividends have been paid
- The industry average dividend yield
- An estimate reflecting the company's expected dividend policy (Correct answer)
- The risk-free rate minus expected capital appreciation
Correct answer: An estimate reflecting the company's expected dividend policy
ASC 718 requires that the dividend yield assumption reflect the company's best estimate of future dividends over the expected term.
CEP Valuation & Financial Analysis 2
Under ASC 718, which method is most commonly used to estimate the fair value of employee stock options?