A Company Has 500,000 Shares Outstanding at $20 Per Share

Essay

A company has 500,000 shares outstanding at $20 per share. To its management, the company grants employee stock options on 10,000 shares. Five thousand of these options can be exercised at a price of $21 any time during the next five years. For five years, the employees thus have the right but not the obligation to purchase shares at the $21 price, regardless of the prevailing market price of the stock. Another 5,000 of these options can be exercised at a price of $25 any time during the next
five years. For five years, the employees thus have the right but not the obligation to purchase shares at the $25 price, regardless of the prevailing market price of the stock. The company's auditor can provide an estimate of the options' value. Using price volatility estimates for the stock, a standard Black-Scholes' valuation model gives an estimated value of $12 per share option with an exercise price of $21 and of $7 per share option with an exercise price of $25. Without expensing the options, the company's pretax earnings are reported as $10 million.
a. What are the pretax earnings per share without expensing the share options granted?
b. What are the pretax earnings per share with expensing the share options granted?