The cost of granting executive stock options with strike prices adjusted by the cost of capital

Purpose – The purpose of this paper is to estimate the cost of granting executive stocks with strike prices adjusted by the cost of capital. Design/methodology/approach – In the paper a Monte Carlo simulation approach developed in Longstaff and Schwartz is used in conjunction with the subjective valuation model developed in Ingersoll to value these executive stock options that are subject to performance hurdles. Findings – The paper finds that standard European Black‐Scholes‐Merton option values overstate the true cost to the firm of granting these executive stock options. The option values also decrease with a higher dividend yield, a higher performance hurdle, a longer vesting period, and a shorter maturity. Research limitations/implications – While the study in the paper is limited to the valuation of executive options, the methodology can be used to study incentive effects of executive stock options that have a performance hurdle. Practical implications – The approach used in this paper to estimate the cost of granting executive stock options is a clear improvement over standard European option pricing approaches that often result in biased estimates. Originality/value – This paper presents a first attempt to integrate the Ingersoll utility‐theoretic model and the Longstaff and Schwartz least squares Monte Carlo algorithm to estimate the subjective value and the objective cost of executive stock options with a performance hurdle. This valuation approach will be useful in the study of other types of executive compensation.