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Hold or Exercise Non-qualified Stock Options?

According to the question, I don't know how to calculate and compare the NPV of cash flow if the client exercise non qualified stock option. The client has two options as follow:

1. Exercise the option and then sell enough shares to generate the cash necessary to pay his income tax and hold the remaining shares as an investment.

2. Using other funds to pay the income tax and hold all shares for investment.

In either case, the client intends to hold the investment shares for three years after he exercises the options before selling them for cash.

The detailed about this question is attached.

Would you please explain step by step how to solve this question? Thank you.

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Question

Your client, Mr. Olmer, has asked for your advice concerning his nonqualified options. He owns a nonqualified option to purchase 10,000 shares of his corporation's publicly traded stock for $11.75 per share. The option is about to expire, and the current market price of the stock is $20. Mr. Olmer is considering two alternatives. He could exercise the option, then immediately sell enough shares to generate the cash necessary to pay his income tax on the bargain element and hold the remaining shares as an investment. His other alternative is to use other funds to pay the income tax and hold all 10,000 shares for investment. In either case, Mr. Olmer intends to hold the investment shares for three years after he exercises the options before selling them for cash. Among other things, your analysis should include the following information:

 A calculation and comparison of the net present value (NPV) of Mr. Olmer's cash flows (from exercise of the option and subsequent sale of stock) under both alternatives if the market price of the stock is $30 per share in three years.

Base your computations on the following assumptions:
 Mr. Olmer's marginal tax rate on ordinary income is 35%.
 The employer stock will be Mr. Olmer's only investment asset. If he recognizes a gain on sale, he can use a 15% rate to compute the tax cost. If he recognizes a loss on the sale, he can deduct the loss only at the rate of $3,000 per year. Assume that the NPV of the tax savings from this series of future deductions is immaterial.
 Mr. Olmer's discount rate is 7%, so the discount factor for computing the NPV of his after-tax cash from the sale of his investment shares in three years is .816.

Solution Summary

Your client, Mr. Olmer, has asked for your advice concerning his non-qualified options. He owns a non-qualified option to purchase 10,000 shares of his corporation's publicly traded stock for $11.75 per share. The option is about to expire, and the current market price of the stock is $20. Mr. Olmer is considering two alternatives. He could exercise the option, then immediately sell enough shares to generate the cash necessary to pay his income tax on the bargain element and hold the remaining shares as an investment. His other alternative is to use other funds to pay the income tax and hold all 10,000 shares for investment. In either case, Mr. Olmer intends to hold the investment shares for three years after he exercises the options before selling them for cash. Among other things, your analysis should include a calculation and comparison of the net present value (NPV) of Mr. Olmer's cash flows (from exercise of the option and subsequent sale of stock) under both alternatives if the market price of the stock is $30 per share in three years.

Base your computations on the following assumptions:
1. Mr. Olmer's marginal tax rate on ordinary income is 35%.
2. The employer stock will be Mr. Olmer's only investment asset. If he recognizes a gain on sale, he can use a 15% rate to compute the tax cost. If he recognizes a loss on the sale, he can deduct the loss only at the rate of $3,000 per year. Assume that the NPV of the tax savings from this series of future deductions is immaterial.
3. Mr. Olmer's discount rate is 7%, so the discount factor for computing the NPV of his after-tax cash from the sale of his investment shares in three years is .816.

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