_________________________________
Name (Please Print)
I did not provide help to any other student nor did I receive help from any person ________________________________________
Name (Please Sign)
Dr. Jensen
Students
may use any reference materials available in the Trinity Library and on the
Web.
Students may not obtain help from any person other than Dr. Jensen. His help is limited to clarification questions regarding what is required for a given question or problem.
Part
1 ESO Tax Benefits
The
starting point for Part 1 is Appendix A of a letter written by Professor Jensen
to Senator Charles E. Schumer. An Appendix B has been added to Professor
Jensen’s original letter, and the letter has not yet been mailed. The purpose of Part 1 of this examination is
to compare how you would write an Appendix B that addresses the tax benefit
controversy of employee stock options (ESOs).
The letter of Walter Schuetze to Senator Schumer, The primary documents useful to this
examination are as follows:
1. “Accounting for Tax Benefits of Employee Stock Options and
Implications for Research,” Accounting Horizons, Vo. 16, No. 1, March
2002, pp. 1-16.
2. Chapter 11 of Business Analysis & Valuation, by K.G. Palepu, P.m. Healy, and V.I. Bernard (South-Western Publishing, 2000, ISBN 0-324-02002-3).
3.
FAS 123 entitled “Accounting for Stock-Based
Compensation.” This standard is
available from the Financial Accounting Standards Board at http://accounting.rutgers.edu/raw/fasb/
Trinity University students may find the document on the path J:\courses\acct5341\ExamHints\Fas123
4. On March 25, 2002, Walter P. Schuetze, former Chief Accountant of the Securities and Exchange Commission, wrote Senator Schumer a letter that leaves no doubt that he opposes booking of employee stock options when they vest. That letter is now on the Web at http://www.trinity.edu/rjensen/theory/sfas123/schuetze01.htm
5.
Bob
Jensen’s reply that points out some opposing arguments. The initial reply is on
the Web at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Initially,
the above document contains an incomplete Appendix B that is Part 1 of this
examination. You are prepare an answer
key for this examination. That key will
complete the Appendix B.
Required:
1.
You are to fill in the cells that have been blanked out
below. Please enter your results in the
Excel spreadsheet that accompanies this examination. That spreadsheet can be downloaded from the
exam02q.xls file on the path http://www.cs.trinity.edu/~rjensen/Exams/5341sp02/exam02/
Warning: Since you will be asked
what happens when the tax rate varies, it is best to derive your spreadsheet
answers in such a way that you can easily derive different outcomes with each
change in the tax rate.
2.
A copy of Hanlon and Shevlon (2002) cited above is provided
in this examination. You are to use
this paper for guidance in completing the spreadsheet required above.
3.
Fill in all the table blanks and answer the questions on
the following pages. Assume that ESO
tax benefits arise only when stock options are exercised. Initially assume that the options in
Appendix B can only be exercised at the end of Year 5.
4.
When you are asked to value these companies at the beginning
of Year 1, pretend that the revenue and expense cash flows are estimates. For guidance on the valuation calculations,
to the Excel workbook on the path
J:\courses\acct5341\ExamHints\FAS123\Appendices.xls
Part
1.1 (40 Points)
Fill in the blanks below after filling in the yellow cells of the Part 1
spreadsheet in the Exam3q.xls file. The
accounting is to proceed according to APB 25 procedures (see Hanlon and Shevlon
(2002)).
|
Year
5 After Exercise of Options |
Nobel
Cash Company |
Nobel
Option Company |
|
Operating revenue |
$320,000
|
$320,000
|
|
Interest revenue |
$12,367
|
$23,424
|
|
Labor expense |
$160,000
|
$0
|
|
Net profit before
income tax (NBOT) |
$172,367
|
$343,424
|
|
Income tax expense |
$51,710
|
$103,027
|
|
Net profit |
$120,657
|
$240,397
|
|
Cash |
$244,329
|
|
|
Capital |
($10,000) |
|
|
Retained earnings |
($234,329) |
|
|
Number of shares |
10,000
|
|
|
Earnings Per Share |
$12.07
|
|
|
Value of options
before exercised |
$0
|
|
|
Value of options
after exercised |
|
|
|
Book Value Per Share |
$24.43 |
|
|
|
|
|
|
|
|
|
|
|
|
Nobel
Option Reconciliation of Cash in Year 5 |
|
|
Appendix A Cash without interest and taxes
= |
$780,000
|
|
|
Interest revenue = |
|
|
|
Less Income Taxes Payable paid in cash = |
|
|
|
Appendix B Cash With Taxes = |
|
|
|
|
|
|
|
|
Nobel
Option Reconciliation of Capital in
Year 5 |
|
|
Appendix A Capital without taxes = |
($160,000) |
|
|
Additional paid-in capital from ESO tax
benefit = |
|
|
|
Appendix B Capital With Taxes = |
|
|
|
|
|
|
|
|
Nobel
Option Reconciliation of Retained Earnings
in Year 5 |
|
|
Appendix A Retained Earnings without
interest and taxes = |
($620,000) |
|
|
Interest revenue = |
|
|
|
Less Income Tax Expense in financial
statements = |
|
|
|
Appendix B Retained Earnings With Taxes = |
|
|
Comment: Normally
the tax payable exceeds the tax overstatement |
|
|
|
due to ESO benefits.
If not, this example assumes that the |
|
|
|
company has neither a tax refund nor a tax loss
carry-forward. If the |
|
|
|
ESO tax benefit exceeds the Income Tax Expense account,
the credit |
|
|
|
to the Capital account for the ESO tax benefit is limited
to the Income |
|
|
|
Tax Expense value before deducting the ESO tax benefit. |
|
|
|
|
|
|
|
|
|
|
|
Initial Investment
and Net Profits |
Nobel
Cash Company |
Nobel
Option Company |
|
0 |
$7,700
|
$10,000
|
|
1 |
$7,700
|
$14,700
|
|
2 |
$15,239
|
$29,729
|
|
3 |
$30,306
|
$59,810
|
|
4 |
$60,427
|
$119,997
|
|
5 |
$120,657
|
$240,397
|
|
NPV = |
$166,254
|
$324,096
|
|
Cost of Capital = |
10.00% |
10.00% |
|
Dividend Cash
Flow Valuation |
At the beginning of Year 1 = $151,709 |
|
|
Residual Income
Model Valuation |
At
the beginning of Year 1 = $151,709 |
|
|
FCF Flow
Valuation |
At the beginning of Year 1 = $151,709 |
|
|
|
|
|
|
Dividend Cash Flow
Valuation |
Nobel
Cash Company |
Nobel
Option Company |
|
Cost of Capital = |
10.0000% |
10.0000% |
|
Year t |
Dividend
Cash Flows |
Dividend
Cash Flows |
|
1 |
$0
|
$0
|
|
2 |
$0
|
$0
|
|
3 |
$0
|
$0
|
|
4 |
$0
|
$0
|
|
5 |
$244,329
|
|
|
ESO New Equity
Investment in Year 5 = |
$0
|
|
|
Dividend Est. Value
of Firm at Time 0 |
At
the beginning of Year 1 = $151,709 |
|
|
Dividend Est. Value
Per Share at Time 0 |
$15.17 |
|
|
|
|
|
|
|
|
|
|
Residual Income
Valuation |
|
|
|
|
|
|
|
Residual Income
Valuation |
Nobel
Cash Company |
Nobel
Option Company |
|
Cost of Capital = r =
|
10.00% |
10.00% |
|
Year t |
Book
Value (0) |
Book
Value (0) |
|
0 |
$10,000
|
$10,000
|
|
|
Net
Profit (t)-(r)(Book Value (t-1)) |
Net
Profit (t)-(r)(Book Value (t-1)) |
|
1 |
$6,700
|
|
|
2 |
$13,469
|
|
|
3 |
$27,012
|
|
|
4 |
$54,103
|
|
|
5 |
$108,290
|
|
|
ESO New Equity
Investment in Year 5 = |
$0
|
|
|
RI Estimated Value of
Firm at Time 0 |
At the beginning of Year 1 = $151,709 |
|
|
RI Est. Value Per
Share at Time 0 |
$15.17 |
|
|
|
|
|
|
|
|
|
|
Free Cash Flow
Valuation |
|
|
|
|
|
|
|
Free Cash Flow
Valuation |
Nobel
Cash Company |
Nobel
Option Company |
|
Cost of Capital = |
10.0000% |
10.0000% |
|
Year t |
FCF(t) |
FCF(t) |
|
1 |
$0
|
$0
|
|
2 |
$0
|
$0
|
|
3 |
$0
|
$0
|
|
4 |
$0
|
$0
|
|
5 |
$244,329
|
|
|
ESO New Equity
Investment in Year 5 = |
$0
|
|
|
FCF Estimated Value
of Firm at Time 0 |
At
the beginning of Year 1 = $151,709 |
|
|
FCF Est. Value Per
Share at Time 0 |
$15.17
|
|
|
|
|
|
Part
1.2 (10 Points) Abnormal Earnings
Valuation
When
comparing the Dividends versus Abnormal Earnings/Residual Income valuation
outcomes, note that these outcomes are identical ($151,709) for the Nobel Cash
Company. They are not identical for the
Nobel Option Company. What is this
difference and how do you account for the difference. Why is that the case, and what is a fundamental problem with
Abnormal Earnings/Residual Income Model valuation?
Hint:
Carefully read the introduction to the
Abnormal Earnings Valuation Method introduction on Page 11-3 of Business
Analysis & Valuation, by K.G. Palepu, P.m. Healy, and V.I. Bernard
(South-Western Publishing, 2000, ISBN 0-324-02002-3). Especially note the underlying assumption and Footnote 1 on Page
11-22.. What are some of the reasons
analysts still prefer the Abnormal Earnings Valuation model?
Part
1.3 Market Value at the End of Year 4
Part
A (5 Points)
What are the book values per share at the end of Year 4?
$______ in the Nobel Cash Company
$______ in the Nobel Option Company
Part
B (10 Points)
The book value in both companies at the end of Year 4 maps to the only asset
of each company --- Cash. If each
company went public with an IPO at the end of Year 4, what factors might make
the market value of a Nobel Cash Company’s share of stock worth more
than the market value of Nobel Option Company?
When answering this question, ignore any possible differences in
off-balance sheet items other than ESOs.
Also assume that at the end of Year 4, it is not known that the firm
will liquidate in Year
Part
C (10 Points)
The book value in both companies at the end of Year 4 maps to the only asset
of each company --- Cash. If each
company went public with an IPO at the end of Year 4, what factors might make
the market value of a Nobel Cash Company’s share of stock worth less
than the market value of Nobel Option Company?
When answering this question, ignore any possible differences in
off-balance sheet items other than ESOs.
Also assume that at the end of Year 4, it is not known that the firm
will liquidate in Year 5.
Part
D (10 Points)
The book value in both companies at the end of Year 4 maps to the only asset
of each company --- Cash. Could the market
value of a Nobel Option Company’s share of stock worth less than
the company’s book value at the end of Year 4?
When answering this question, ignore any possible differences in
off-balance sheet items other than ESOs.
Also assume that at the end of Year 4, it is not known that the firm
will liquidate in Year 5
Part
1.4 (10 Points) ESO Tax Benefits
The
book value in both companies at the end of Year 4 maps to the only asset of
each company --- Cash. Could the market
value of a Nobel Option Company’s share of stock worth less than
the company’s book value at the end of Year 4?
When answering this question, ignore any possible differences in
off-balance sheet items other than ESOs.
Also assume that at the end of Year 4, it is not known that the firm
will liquidate in Year 5
Part
1. 5 ESO Expense Recognition
FAS
123 is provided on the path J:\courses\acct5341\ExamHints\Fas123
This file is 115 pages, and you need not print out the entire document to
answer the assignments below. You may
print out parts of the document (by selecting text and pasting into a Word
document), or you may read the small amount you need for this examination on a
computer’s monitor without printing any part of FAS 123.
Paragraph
74 of FAS 123 reads as follows.
Paragraphs 75-117 of this (FAS 123)
appendix discuss the reasons for the Board's principal conclusions on
recognition and measurement issues, which support the Board's belief that
recognition of stock-based employee compensation cost determined according to the
fair value based method is preferable to continued application of Opinion 25
with only pro forma disclosures of the effect of recognizing stock-based
employee compensation cost. That discussion begins with the basic issue of why employee stock
options give rise to recognizable compensation cost.
Part
A (10 Points)
In your own words, briefly summarize in less than 400 words, the arguments for
the FASB conclusions in Paragraph 74 above. Only the first 400 words will be graded.
Part
B (10 Points)
In your own words, briefly summarize in less than 400 words, the arguments against
the FASB conclusions in Paragraph 74 above. Only the first 400 words will be graded
Parts
2 and 3 of this examination are provided in a separate handout.