valuepersharethatwewillthencomparetothemarketprice
to decide whether a stock is under- or overvalued. For
instance,wemayconcludethatastockwithapriceof$25per
shareisreally worthonly$12per share.Usingthecurrent
market pricetoarrive atthevalue oftheoptionsand then
usingthisoptionvaluetoestimateanentirelydifferentvalue
per share seems inconsistent.
There is a solution. We can value the options using the
estimatedvaluepershare.Thiscreatescircularreasoningin
ourvaluation.Inotherwords,we needtheoptionvalueto
estimatevaluepershare,andthevaluepersharetoestimate
theoptionvalue.Wecanestimatethevaluepershareusing
thetreasurystockapproach,andwecanthenconvergeonthe
proper value per share by iteration.
19
Thereisanotherrelatedissue.Whenoptionsareexercised,
theyincreasethenumberofsharesoutstanding,andthushave
aneffect onthestock price.Inconventionaloptionpricing
models,theexerciseoftheoptiondoesnotaffectthestock
price. These models have to be adapted to allow for the
dilutive effect of option exercise.
Taxation
When options are exercised, the firm can deduct the
differencebetweenthestockpriceatthetimeandtheexercise
priceasanemployeeexpensefortaxpurposes.Thispotential
tax benefit reduces the drain on value created by having
options outstanding. To provide an illustration of the
magnitudeofthetaxbenefit,Ciscoclaimedataxdeductionof
$2.5 billion for option exercise in 2000, almost entirely