CEP Valuation & Financial Analysis 3 — Questions and Answers
Question 1: What does the term 'volatility' represent in the context of equity compensation valuation?
- The rate at which options vest over time
- The annualized standard deviation of continuously compounded stock returns (Correct answer)
- The difference between high and low stock prices in a given year
- The beta of the stock relative to the market index
Correct answer: The annualized standard deviation of continuously compounded stock returns
Volatility in option valuation is the annualized standard deviation of the continuously compounded returns of the underlying stock.
Question 2: When a company lacks sufficient trading history to calculate historical volatility, ASC 718 permits using:
- Only implied volatility from traded options
- A peer group's historical volatility or a blend of peer and own data (Correct answer)
- A regulatory-set standard volatility rate
- Zero volatility as a conservative assumption
Correct answer: A peer group's historical volatility or a blend of peer and own data
ASC 718 allows companies with limited history to use volatility of comparable peer companies or a blend of own and peer volatility.
Question 3: A performance share unit (PSU) with a market condition (e.g., total shareholder return vs. peers) should be valued using:
- Black-Scholes model with standard inputs
- Intrinsic value at grant date
- Monte Carlo simulation (Correct answer)
- Book value per share
Correct answer: Monte Carlo simulation
Market conditions must be incorporated into the grant-date fair value using a model such as Monte Carlo simulation that can model the probability distribution of outcomes.
Question 4: Under ASC 718, once a grant-date fair value is determined for an award with a market condition, it is:
- Revised at each reporting date if performance expectations change
- Fixed and not revised regardless of whether the market condition is achieved (Correct answer)
- Reduced to zero if the market condition is not met at vesting
- Recalculated annually based on current stock price
Correct answer: Fixed and not revised regardless of whether the market condition is achieved
For awards with market conditions, the grant-date fair value is set at grant and is not subsequently adjusted even if the condition is not met.
Question 5: What is the primary reason companies use a lattice (binomial) model rather than Black-Scholes for certain stock option grants?
- Lattice models always produce a higher fair value
- Lattice models can accommodate changing inputs over the option's life (Correct answer)
- Lattice models require fewer inputs than Black-Scholes
- Lattice models are required by FASB for large public companies
Correct answer: Lattice models can accommodate changing inputs over the option's life
Lattice models are flexible because they allow inputs such as volatility and interest rates to vary at different points in time across the option's contractual life.
Question 6: Which of the following correctly describes the risk-free interest rate input in the Black-Scholes model for employee stock options?
- The company's weighted average cost of capital
- The yield on U.S. Treasury securities with a maturity matching the expected term (Correct answer)
- The Federal Funds rate on the grant date
- The prime lending rate at grant date
Correct answer: The yield on U.S. Treasury securities with a maturity matching the expected term
The risk-free rate should correspond to U.S. Treasury securities (typically zero-coupon) with a term equal to the option's expected term.
Question 7: A restricted stock unit (RSU) without dividend equivalent rights is granted when the stock price is $30 and pays no dividends. What is its grant-date fair value?
- Less than $30, discounted for lack of marketability
- $30
- $30 minus present value of expected dividends (Correct answer)
- Determined by a lattice model
Correct answer: $30 minus present value of expected dividends
RSUs without dividend equivalent rights must be discounted for expected dividends because holders don't receive dividends during the vesting period; with no dividends, the fair value equals the stock price.
CEP Valuation & Financial Analysis 3
What does the term 'volatility' represent in the context of equity compensation valuation?