Instructional Case: VLT Corporation
2008 Managers Incentive Stock Option Plan
The compensation of senior executives in the U. S. is typically composed of salary,
bonus, and long-term incentives. Quite often, long-term incentives involve stock options,
whereby an executive is granted the right to buy shares of common stock in the company at a
predetermined price within a specified period of time. According to a recent Conference Board
survey, over 80 percent of U. S. executive compensation plans use stock options.
In 2008, VLT Corporation undertook a review of its compensation package for top
managers. After due consideration, the board of directors put a proposed “managers’ incentive
stock option plan” before the stockholders at its annual meeting. The stock option plan was
approved by 85% of the shareholders and was implemented on March 1, 2008.
Under the plan, the company issued 3,000,000 options on its common stock to 40 top
executives on May 1, 2008. The plan entitles each executive to purchase VLT common stock
for $72.08 per share for each option received (the number of options received by an executive
depends on management level). The options cannot be exercised until they vest on May 1, 2010.
If not exercised, the options expire on July 31, 2010. The options cannot be pledged or sold by
the executives. The executives must remain in the employment of VLT Corporation during the
service period: voluntarily or involuntarily terminated executives forfeit any unvested stock
options.
VLT Corporation’s stock is traded on the New York Stock Exchange. On May 1, 2008,
the common stock closed at $72.08 per share. The par value of VLT common stock is $1.00 per
share. The corporation anticipates that the past volatility of its shares can reasonably be used as
a predictor of future volatility. Based on past experience with executive turnover, VLT projects
a 5% annual turnover rate. Assume that U. S. government zero coupon bonds maturing on April
30, 2008 were trading with an implied yield of 2.5% on the grant date. The dividend yield rate
on May 1, 2008 was approximately 1.2%. The combined federal and state corporate tax rate is
40%.
Due dates

Prepare Parts 1 and 2 for submission on Thursday, Feb. 25, 2011. Individual work
ONLY

Prepare Part 3 is not necessary this semester since the options were underwater in 2009.

Prepare Part 4 (in your VLT group) and submit by April 1 for an “early bird bonus
point.”
1.
Using the Black Scholes Model.
a.
Estimating volatity for use in BSOP for the 2008 stock option plan. Use the stock price
information provided in Excel sheets to estimate the volatility of the VLT Corporation
stock using daily, weekly and monthly stock prices. For the monthly and weekly data, try
one-year and two-year periods. There are not enough daily data points to do a full one or
two year estimation period so use the maximum possible for the daily with a comparison
to weekly for the same time period. I do NOT want complete printouts showing all the
stock prices – just tell me the beginning and ending dates of the time series you used to
get each volatility figure. You may want to refer to guidelines the FASB provided
beginning at ASC 718-10-55-35 (I actually thought the guidance was better in the
original SFAS No. 123 (not 123R) since it included a numeric example so you could also
look in Appendix F (paragraphs 396-411) which is still available at fasb.org but not in the
codification). It includes an example.
b.
Estimate the fair value of the options issued May 1, 2008. Use the Excel sheet provided
(from Mario Reyes for Boeing) to estimate the option price for the VLT Corporation
2008 stock option plan as of May 1, 2008. What is the range of fair value estimates from
using the volatility figures computed in 1-a above?
c.
Consider variations in the inputs to the BSOP model. Use the Excel model provided to
explore the impact of changes in the variables. In each case, hold all other variables
constant and examine the impact on the fair value. For example, what if the VLT stock
paid no dividend? What if the service period for the stock options was 4 years in length
instead of 2 years? What if the exercise period were 5 years instead of 3 months? What
if the volatility doubled? What if the option price had been $150 instead of $198.94?
What if the risk free rate has been 4% instead of 2%? And so on. You don’t need a
printout for each variation – you can just add columns or jot down the answers. The
point is to gain some familiarity with the impact of changes in the inputs to the model
d.
Write a one paragraph description of what you learned from doing part 1c. In other
words, which variables have a positive effect (increase fair value)? Which variables have
negative effect (decrease fair value)? Which variable has the biggest impact on the fair
value of the VLT 2008 options?
2.
Journal entries.
Regardless of your answers to #1, assume that the fair value of the options is $8.42 and prepare
all journal entries necessary (including deferred income taxes) for the events described. [Your
answer will be different because I used a different spreadsheet model that tends to predict
somewhat lower fair values. It came from a Journal of Accountancy article years ago.]
a. Using the 5% turnover rate, prepare any journal entries needed on May 1, 2008 (the
grant date).
b. Prepare any journal entries needed at December 31, 2008 assuming that no executives
terminated their employment before the end of the year.
c. On April 1, 2009, there was a 100% stock dividend which, in effect, increased the
number of options outstanding by 100%. Note that the total compensation expense
computed earlier does NOT change. The new fair value is $4.21, the revised option price
is $36.04 and there are now 6,000,000 options.
d. Prepare any journal entries needed at December 31, 2009 assuming that executives with
680,000 (340,000 before stock dividend) options quit their jobs before their stock options
vested (you may assume that the terminations occurred ratably throughout the year).
Based on this rate of forfeiture, the company revises its projected turnover rate to 3% per
year.
e. Prepare any journal entries needed at May 1, 2010 assuming that an executive with
500,000 (250,000 before stock dividend) options left VLT on March 1, 2010. This means
that 4,820,000 options vested on May 1, 2010.
f. Prepare a journal entry to record the exercise of 4,815,000 options between June 10 and
June 21, 2010 at a weighted average market price of $43.69. The remaining 5,000
options expired unexercised on July 31, 2010.
Possible check figures: As of 1/1/10, VLT had $2,368,500 in additional paid in capital
related to excess tax deductions on earlier stock option programs. The unrecognized
stock-based compensation at 12/31/08 was $15,198,100 and at 12/31/09 it was
$3,961,189.
3.
Earnings per share.
Compute earnings per share for 2008 using the following information:
The average market price per share of common in 2009 was $25.94
Net income as reported for 2009
$135,974,300
Numerator effects include:
Dividends on convertible preferred stock
4,000,000
After tax interest on convertible bonds
1,871,521
Weighed average common shares for basic
Other adjustments to the denominator include:
Adjustment for convertible bonds
Adjustment for convertible preferred stock
8,000,000
20,000,000
(Note: Your answer may not be the same number that you will disclose in the comparative 2010
financial statements due to any stock splits or stock dividends during the year.)
The options were underwater during 2009. Accordingly, this assignment will not be turned in
for Spring 2011 course.
4.
Follow-up assignment – to complete Financial Disclosure Project
a.
From the VLT financial statement disclosure project, note that 10,000,000 new
executive stock options were granted on September 1, 2010 at an exercise price
of $37.59. The market price on the grant date was $37.59. The fair value was
determined to be $7.32 per share. Prepare the 2010 journal entries that VLT
made with respect to the new series of compensatory stock options issued.
b.
Prepare the footnote disclosure that will be needed for the 12/31/10 comparative
financial statements. {Other necessary details with respect to the convertible
preferred and convertible bonds are provided in the VLT project and/or the
earnings per share project.}
Extra credit point is available for turning in draft of footnote on or before April 1, 2011.