Expert Answer:Exotic Cuisine Case Study – Business Assignment He


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Exotic Cuisines
As a new graduate, you have taken a management position with Exotic
Cuisines, Inc., a restaurant chain that just went public last year. The
company’s restaurants specialize in exotic main dishes, using ingredients such
as alligator, buffalo, and ostrich. A concern you had going in was that the
restaurant business is very risky. However, after some due diligence, you
discovered a common misperception about the restaurant industry. It is widely
thought that 90 percent of new restaurants close within three years; however,
recent evidence suggests the failure rate is closer to 60 percent over three
years. So, it is a risky business, although not as risky as you originally thought.
During your interview process, one of the benefits mentioned was employee
stock options.
Upon signing your employment contract, you received options with a strike
price of $50 for 10,000 shares of company stock. As is fairly common, your
stock options have a three-year vesting period and a 10-year expiration,
meaning that your cannot exercise the options for a period of three years, and
you lose them if you leave before they vest. After the three-year vesting period,
you can exercise the options at any time. Thus, the employee stock options
are European (and subject to forfeit) for the first three years and American
afterward. Of course, you cannot sell the options nor can you enter into any
sort of hedging agreement. If you leave the company after the options vest,
you must exercise within 90 days of forfeit.
Exotic Cuisines stock is currently trading at $24.38 per share, a slight increase
from the initial offering price last year. There are no market-traded options on
the company’s stock. Because the company has been traded for only about a
year, you are reluctant to use the historical returns to estimate the standard
deviation of the stock’s return. However, you have estimated that the average
annual standard deviation for restaurant company stocks is about 55 percent.
Because Exotic Cuisines is a newer restaurant chain, you decide to use a 60
percent standard deviation in your calculations. The company is relatively
young, and you expect that all earnings will be reinvested back into the
company for the near future. Therefore, you expect no dividends will be paid
for at least the next 10 years. A three-year Treasury note currently has a yield
of 3.8 percent, and a 10-year Treasury note ahs a yield of 4.4 percent.
1. You are trying to value your options using BSM Model. What values would
you assign, using 3-year and 10-year as the time to maturity?
2. Suppose that, in three years, the company’s stock is trading at $60. At that
time, should you keep the options or exercise them immediately? What are
some important determinants in making such a decision?
3. Your options, like most employee stock options, are not transferable or
tradable. Dose this have a significant effect on the value of the options?
4. Why do you suppose employee stock options usually have a vesting
provision? Why must they be exercised shortly after you depart the
company even after they vest?
5. A controversial practice with employee stock options is repricing. What
happens is that a company experiences a stock price decrease, which
leaves employee stock options far out of the money or “underwater.” In
such cases, many companies have “repriced” or “restruck” the options,
meaning that the company leaves the original terms of the option intact, but
lowers the strike price. Proponents of repricing argue that because the
option is very unlikely to end in the money because of the stock price
decline, the motivational force is lost. Opponents argue that repricing is in
essence a reward for failure. How do you evaluate this argument? How
does the possibility of repricing affect the value of an employee stock
option at the time it is granted?
6. As we have seen much of the volatility in a company’s stock price is due to
systematic or marketwide risks. Such risks are beyond the control of a
company and its employees. What are the implications for employee stock
options? In light of your answer, can you recommend an improvement over
traditional employee stock options?

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