Explain how management determined that only 4.7 million of new options would be granted in exchange for the 14.3 million options tendered

Question

.0/msohtmlclip1/01/clip_image002.gif>MANAGEMENT
120B
CASE
2

Starbucks
Corporation

EMPLOYEE STOCK
OPTION ACCOUNTING

Objective:
Employee stock option accounting at Starbucks Corporation

Starbucks
Corp., the passionate purveyors of coffee and everything else that goes with a
full and rewarding coffeehouse experience, included the following table in its
2009 annual report:

Total
stock based compensation and ESPP expense recognized in the consolidated
financial statements

Fiscal Year Ended
(
in millions)
Sep 27, 2009 Sep
28, 2008
Sep 30, 2007
Stock
option expense
$ 61.6 $
57.6
$ 92.3
RSU expense 16.6 5.6 ”
ESPP
expense
5.0 11.8 11.6
Total
stock- based compensation expense on
$ 83.2 $
75.0
$ 103.9
the
consolidated statements of earnings
Total
related tax benefit
$ 29.3 $
24.0
$ 35.3

Starbucks maintains several share- based
compensation plans that permit the company to grant employee stock options,
restricted stock, and restricted stock œunits or RSUs. Starbucks also has an
employee stock purchase plan (œESPP) that allows participating employees to
buy shares at a discounted price. At some companies, the discount can be as
much as 15% lower than the prevailing market price. Stock options to purchase
Starbucks common shares are granted at an exercise price equal to the market
price of the stock on the date of grant. Most options become exercisable in
four equal installments beginning one year from the date of the grant and
expire 10 years from the date of grant. Suppose Starbucks issues 100,000
employee stock options on January 1, 2010, and that one-fourth of the options
vest in each of the next four years, beginning on December 31, 2010. For
financial reporting purposes, the company elects to separate the total award
into four groups (or tranches) according to the year in which each vests.
Starbucks then measures the compensation cost for each vesting date tranche as
if it was a separate award. The following table provides details about each
vesting tranche:

Vesting Date Shares Vesting Fair Value per
Option
Dec. 31, 2010 25,000 $ 2.00
Dec. 31, 2011 25,000 $ 3.20
Dec. 31, 2012 25,000 $ 4.80
Dec. 31, 2013 25,000 $ 7.00

Requirements

Prepare
a letter to the President of Starbucks to answer the following questions.

  1. Each
    tranche has the same exercise price” the market price of the stock on the
    grant date, or $ 23 on January 1, 2010. Explain why the option fair value
    increases with the vesting date.

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Management
120B

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2. Consider
only the first option tranche vesting on December 31, 2010, and suppose that
the price of Starbucks common stock is $ 40 on that date. Determine the
compensation expense that Starbucks would record in 2010 for this first option
tranche. No stock options are exercised by employees that year.

3.
Suppose that the price of Starbucks
common stock falls to $ 35 as of December 31,

2011.
Considering only the first two option tranches, determine the compensation
expense that Starbucks would record in 2011. No stock options are exercised by
employees that year.

4. At
the beginning of 2012, employees exercise 10,000 of the 2010 options. Employees
hand over the 10,000 options along with $ 23 per option” the exercise price”
and receive from the company an equal number of shares. The price of Starbucks
common stock is $ 35 per share on the exercise date. Prepare the journal entry
Starbucks will use to record this transaction.

5. In
2009, Starbucks shareholders approved a management proposal to allow for a
one-time stock option exchange program, designed to provide employees an
opportunity to exchange certain outstanding but underwater stock options for a
lesser amount of new options granted with lower exercise prices. Under this
proposal, employees could exchange options granted with an exercise price
greater than $ 19 and receive new options with an exercise price of about $ 15.
A total of 14.3 million stock options were tendered by employees and 4.7
million of new stock options were granted. According to the companys financial
statement note: œNo incremental stock option expense was recognized for the
exchange because the fair value of the new options, using standard employee
stock option valuation techniques, was approximately equal to the fair value of
the surrendered options they replaced. Explain why a company might offer
employees the opportunity to exchange underwater stock options for new options
with a lower exercise price?

6. Explain
how management determined that only 4.7 million of new options would be granted
in exchange for the 14.3 million options tendered. In other words, why might
management be reluctant to grant 10.0 million of the new options?

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