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Evidence on exercise pricing in CEO option grants in two countries

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Abstract

This paper examines the relationship between exercise prices, grant size and CEO risk aversion employing a data set of Australian option grants characterized by exercise prices that vary relative to the stock price. We argue that Australian exercise price and grant size decisions provide an appropriate framework for evaluating the consequences of the U.S. practice of granting at-the-money options. Using a 3SLS estimation, we find that exercise prices are positive in grant size when internalizing CEO risk aversion but less so for the U.S. relative to Australia. We find also that CEO risk aversion is negatively related to both exercise prices and grant size in Australia but negatively related only to exercise prices in the U.S. A positive relation found between CEO risk aversion and grant size in the U.S. implies that risk aversion is addressed with larger grant sizes to compensate for fixed exercise prices.

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Notes

  1. Murphy (1999) reports that 94.8 % of option grants to U.S. CEOs in fiscal 1992 are granted at-the-money, with Banerjee et al. (2008) documenting that in 2005 99.92 % of option grants were granted at-the-money.

  2. Issuing a non-qualified options (i.e., in-the-money on the grant date) may not be fully-deductible if the value of the non-performance-based compensation exceeds 1 million dollars. In addition, grants of non-qualified options are likely to result in the tax liability to the manager exceeding the tax benefit to the issuing company (Palmon et al. 2008). For financial reporting, pre-FAS 123R grants of in-the-money options were expensed, but not grants of at-the-money and out-of-the-money options.

  3. Tang (2012) further argues that exercise prices should vary with the vesting period.

  4. This is consistent also with Edmonds and Gabaix (2011) who show that risk aversion requires higher incentives to deliver a given effort.

  5. Young and Quintero (1995) argue that out-of the-money grants are unpopular given that effort exerted by a risk-averse CEO contributes less to her expected utility than in-the-money grants at the same cost. Palmon et al. (2008) further note that in-the-money grants are rare due to mandated expensing and taxation of the difference between the fair market value of the underlying and the exercise price for non-qualified options.

  6. Australian executive stock option plans are partially surveyed in Taylor and Coulton (2002) while U.S. executive stock option plans are surveyed in Hall (1999).

  7. For example, North Limited, ICI Australia Limited and Ashton Mining Limited prescribed an exercise price being the average of the stock price for the prior 5 trading days, with some companies (e.g., Energy Equity Limited) adding a requirement for a premium to market and others (e.g., Orbital Engine Limited) adding a requirement for a discount. Amcor Limited and BRL Hardy Limited, for example, granted full discretion to their compensation committees.

  8. The recent history of Australian tax provisions in relation to executive option grants and coincident with our sample period is documented in Grigaliunas and Trainor (2001). The U.S. system is outlined in Murphy (1999). In-the-money grants are not considered performance-based compensation in accord with Section 162 (m) of the Internal Revenue Code and are therefore not tax deductible if an executive’s total non-performance-based compensation exceeds $1 million in a given year. At the same time, prior to the introduction of FAS 123R in 2005 only in-the-money options were expensed in the income statement.

  9. See, for example, the Income Tax Assessment Act, division 83A as amended in 1997.

  10. Since grants are typically approved by shareholders at Annual General Meetings grants made within 5 months after the close of the preceding fiscal year are associated with that year (Corporations Act, sec. 250N). About half our grants are dated within this 5-month interval; the remainder are dated within the 7-month interval prior to the current fiscal year-end.

  11. We also measure moneyness using a 5 % threshold. The results are qualitatively similar and available on request.

  12. Given Australian and U.S. CEOs have similar equity-based compensation (refer Table 1) we assume the wealth of Australian CEOs is likewise similar (Conyon et al. 2011).

  13. We perform a Hausman test (not reported) which fails to detect endogeneity in either set of estimations.

  14. We would like to thank an anonymous referee for this suggestion.

  15. Ownacc dummy is negatively correlated with Cash-to-stock \((r = -0.182, p=0.000)\) as expected, but is unrelated to CEO ten_age.

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Acknowledgments

We are grateful to Don Chance, Vidhan Goyal, Garry Twite, Paul Brockman, Terry Walter and Takeshi Yamada for their valuable comments on earlier drafts. We also thank seminar participants at the FMA European 2013 meeting.

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Authors and Affiliations

  1. School of Accounting and Finance, University of Adelaide, Adelaide, 5005, Australia

    Jean M. Canil & Bruce A. Rosser

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Correspondence to Jean M. Canil.

Appendix: Variable definitions

Appendix: Variable definitions

Main variables

 

   Exercise price-to-stock price

Exercise price stated in the option plan over the stock price at grant date

   Cash-to-stock (A_pS)

Measures risk aversion and is the natural logarithm of the ratio of a CEO’s salary (A) to the CEO’s effective equity holdings (pS) which are defined as the sum of the CEO’s percentage stock holding \((p_{s})\) and the percentage delta-weighted option holdings \((\Delta q)\), both multiplied by market value of equity (Carlson and Lazrak 2010)

   Grant size

Number of options granted divided by the number of outstanding ordinary shares prior to grant, multiplied by 100

Firm characteristics

 

   Ln (total assets)

Natural logarithm of total assets

   Market equity

Number of outstanding shares multiplied by the stock price at fiscal year-end

   Tobin’s Q

Market value of assets divided by book value of assets, where market value of assets is book value of assets plus market equity less book value of common stock

   Investment-to-capital

Capital expenditure divided by gross PPE

   Financial leverage

Total debt divided by total assets

   Stock volatility

Annualized standard deviation of pre-award monthly stock returns over 36 months prior to grant

   Prior stock return

12-month stock return preceding the grant date

   ROA

Earnings before interest and tax divided by total assets

   Capital expenditures

Capital expenditure divided by total assets

   Dividend payer

Coded (\({=}1\)) if paid a dividend in a given year

CEO characteristics

 

   CEO ownership

Sum of CEO stock units held by the CEO divided by the number of outstanding ordinary shares prior to grant

   CEO tenure

Number of years as CEO in company

   CEO age

Age in years of the CEO

   CEO ten_age

CEO tenure divided by CEO age

   CEO ten_age missing

Indicator variable that takes the value of 1 when CEO age or CEO tenure is missing, 0 otherwise. CEO ten_age is set to 0 when CEO ten_age missing equals 1

   Total compensation

Sum of option grant value, restricted stock value, bonus and salary

   Salary-to-total compensation

Salary divided by total compensation

   Equity-to-total compensation

Sum of option grant and restricted stock values divided by total compensation

   Option grant value

Option delta multiplied by the stock price and number of options granted

   Option delta \((\Delta )\)

Partial derivative of Black and Scholes call value with respect to the stock price, \({\delta C_{BS} }/{\delta S}\) or \(N\left( {d_1 } \right) \), adjusted for dividends

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Canil, J.M., Rosser, B.A. Evidence on exercise pricing in CEO option grants in two countries. Ann Finance 11, 383–410 (2015). https://doi.org/10.1007/s10436-015-0262-4

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