Black-Scholes vs. the IRS: Gains, Losses, and Compensation Adjustments from Revaluing Stock Options after Spinoffs

• In Event: Financial Accounting and Reporting 3

Abstract

Following a spin-off, the Black-Scholes values of managers' option portfolios can significantly increase or decrease in value even though the modification is tax free under IRS regulations. While higher ex-post volatility increases option values, it also exposes the manager to greater risk. Conversely, lower ex-post volatility will lead to a decrease in the managers’ option wealth, however, this potential wealth loss may be more than offset by the manager facing lower risk. In both cases we document firms' significantly increasing managers' subsequent cash compensation. In neither case did we find any significant change in the value of future stock awards. IRS rules provide no guidance to firms in their selection of the fair market value used in the option modification process. We find that firm's choice of a low conversion price leads to large wealth gains by managers. We also find that proxies for weak corporate governance are associated with greater deviations between the chosen conversion price and the closing price.

Authors

• Tao Sun, Drexel University

• Mark E Vargus, Drexel University

• Anthony P Curatola, Drexel University