offsettingitsoperatingincomeof$2.67billionthatyearand
allowing Cisco to effectively pay little in taxes. We can
accountforthistaxdeductibilityinvaluingemployeestock
options in three ways:
1.Reducetaxratesonoperatingincometoreflectemployee
optiondeductions.Tocomputefreecashflowtothefirm,we
use after-tax operating income. If a firm has substantial
numbersofoptionsoutstanding,wecoulduseamuchlower
tax rate in the near years of the forecasts to reflect tax
deductions from employee options.
20 This will increase cash flows in those years (and
consequently value).We wouldmovethe taxratestoward
statutorytaxratesasweapproachterminalvalue,sincethe
option exercise tax savings will fade over time.
2.Taxeffecttheexercisevalueofoptions.Asimplerwayto
estimatethetaxbenefitistomultiplythedifferencebetween
thestockpricetodayandtheexercisepricebythetaxrate;
clearly, this would make sense only if the options are
in-the-money. While this does not allow for the expected
price appreciation over time, it has the benefit of simplicity.
3.Taxeffectthefairvalueofoptions.Analternativewayof
estimatingthetaxbenefitistocomputetheafter-taxvalueof
the options:
After-taxvalueofoptions=Valuefromoptionpricingmodel
(1 − Tax rate)
This approach is also straightforward and allows us to
considerthetaxbenefits fromoptionexercisein valuation.
Oneoftheadvantagesofthisapproachisthatitcanbeused