Introduction and Business Problem

Joseph has been offered a job at Morton's Horticultural Products (MHP) and as part of the compensation
package, he has been offered 20,000 shares of MHP stock at a strike price of $30 that will vest at the end
of 4 years of his employment. The case requires stock option valuation outcomes be probabilistically
analyzed based on increases or decreases in the stock price. Those considerations then need to be
rationalized into a statistically informed plan.
Additionally, Mark is an experienced investor who is selling 10500 options at $5.21 premium that can be
exercised at $30 strike price the end of Joseph’s first year with MHP. Joseph needs to assess the type of
investment Mark is offering, the different payoffs, and his risk vs. benefits in the investment that Mark
has offered. It also requires us to assess this investment for Mark. The analysis required for this case
includes stock valuation using a binomial price asset model.

Summary of Results

The results of the analysis performed are captured in Tables 1 through 4. Table 1 demonstrates the
expected stock price from 2013 to 2017. The table includes calculations for both Joseph's assumed
probability and risk neutral probability. Joseph’s compensation and net present value based on these is
further explained in the analysis section. In Table 2, the stock option premium that Joseph would pay to
Mark for the stock options is portrayed for both Joseph’s assumed probability (p=0.5) and risk neutral
probability (p=0.25) of stock going up. It shows the values for a 1-year and 4-year stock option. Mark’s
investment analysis is shown in Table 4 when he offers the stock options to Joseph at a premium of
$5.21. Table 5 investigates Mark’s investment had the premium been $2.61 obtained by using a risk
neutral probability. The details of these tables are further explained in the analysis section below.

Analysis

Joseph’s assumed probability and risk neutral probability

Binomial asset pricing calculation:
Let x = number of ups and y = number of downs in the Binomial tree for a given year.
Probability at that point = nCx px (1-p)y
Stock value at that point = S0 ux dy
Where, p = 0.5 or 0.25
u = percentage increase in the stock price = 1.05*1.3 = 1.365,
d = percentage decrease in the stock price = 1.05*0.9 = 0.945 and
S0 = $30 (initial stock price)
For example, in 3 year after 2 ups and 1 down,
Probability = 3C2 0.52 (1-0.5)1 = 0.375
Stock value = 30*1.3652*0.9451 = 52.82
Table 1 was constructed using these formulae. This can be extended to a multi period analysis.

Expected Value of stock and stock option

The first part of the analysis considers Joseph’s stock options with MHP. Table 1 shows expected stock
values with Joseph’s assumption of MHP stock prices increasing or decreasing (at p = 0.5). From his

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assumptions, the expected unit stock price in 2017 will be $53.39 as shown in equation 1. Using risk
neutral probabilities, the expected value of the stock comes at $48.54 as shown in equation 2.
Similarly, Table 2 extends this calculation for a 4-year period using both Joseph’s assumed and risk
neutral probabilities.
Joseph stands to earn (53.39-30) x 20,000 = $467,800 using p =0.5 and (48.54-30) x 20,000 = $370,800
using p = 0.25 at the end of 4 years.
The expected value of a stock option at the end of 4 years is $ 19.55 using p=0.5. Using risk neutral
probabilities, the stock option is valued at $15.72 at the end of 4 years.

Expected Stock Price (Joseph’s assumption) = (104.15*0.0625) + (72.10*0.25) + (49.92*0.375) +

(34.56*0.25) + (23.92*0.0625) = $53.39 (equation 1)
Expected Stock Price (Risk neutral probabilities) = (104.15*0.03125) + (72.10*0.1875) + (49.92*0.375) +
(34.56*0.3125) + (23.92*0.09375) = $48.54 (equation 2)

NPV and FV calculation:

The net present expected value based on Joseph’s assumption and risk neutral probabilities is $43.92$
and $39.93 respectively. The values are calculated for vest option in 4 years I.e., in 2017 as are described
below.
Net Present Value, NPV (Joseph’s assumption) = 0/1.05 + 0/1.052 + 0/1.053 + 53.39/1.054 = $43.92
Net Present Value, NPV (risk neutral probability) = 0/1.05 + 0/1.052 + 0/1.053 + 48.54/1.054 = $39.93
Whereas the corresponding future value of $30 stock would be 36.47$ in 4 years as shown below
FV = 30 (1 + 0.05) ^4 = $36.47

MHP Stock Option analysis

Given the expected stock price under either Joseph’s assumption or risk neutral probability is higher
than FV of $36.47, he is expected to earn significant profits by accepting MHP job offer compared to
bank return on long term deposits. The Net Present value of his stocks is much higher than $30 as shown
above. Hence, stock options provide Joseph with much better time value for his money. Also, when
considering either Joseph’s assumption or risk-free probability, there is only 0.0625 or 0.09375 chance
of not earning profit for the given job offers. Therefore, MHP job offer constitutes a good opportunity
for Joseph and he should consider joining MHP and accepting MHP “long” stock options.

Mark’s Offer analysis

Mark offers Joseph 10,500 stock options at his calculated value of 5.21$, which does not consider risk
free probability as shown below:
[0.50 x (40.95-30) + 0.50 x (0)]/1.05 = 5.21 + 0 = $5.21 for a 1-year period
However, Joseph primary assumption should include risk free probability as follows:
p = (1+r)-d / (u-d) = (1+0.05)-0.945/ (1.365-0.945) = 0.25 (equation 2: Case appendix)

Where, r = risk-free return rate = 0.05 per information provided.

The option value using the binomial asset pricing model with risk neutral probability is as below:
[0.25 x (40.95-30) + 0.75 x (0)]/1.05 = 2.61 + 0 = $2.61 for a 1-year period.

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Failure to consider risk neutral scenario by Joseph has resulted in the above price difference for stock
option premium. Hence, Joseph’s assumptions of 50% rise and 50% fall are unrealistic. The option is
valued at $5.21 nearly double vs. $2.61 using the risk neutral probability. His investment with Mark as
shown in Table 3 and discussed below demonstrates his risks in his valuation. Under his assumptions, for
10,500 stock options, Joseph’s maximum profit is only $2737.50 (refer to table 3). Note that option is
not exercised when the stock price goes down, resulting in Joseph losing all his premium value paid to
Mark initially.
Joseph’s expected profit @ $5.21 stock option premium = 0.5*60,225 – 0.5*54,750 = $2737.5.
See Table 3 for a detailed description.

Mark’s Investment Analysis

From the results in Table 3, Mark developed a risk-free model for himself. He created an arbitrage and
stands to profit from either the rise or fall of the stock price irrespective of their probabilities. He
covered his base by purchasing 9125 units and selling a higher number of options to Joseph. The 10,500
stock options were sold to cover his risk i.e., the loss from the stock falling and the difference in stocks
that he would have to buy and give to Joseph if the stock rises. This is calculated as follows:

S (stock units) * $30 = (S-9125) *40.95 + 9125*28.35. Therefore, S = 10500

Thus, from Table 3, Mark profits $27,375 under all circumstances.

At the call option value of $2.61 calculated at risk neutral probability, Mark breaks even and makes no
profit or no loss. Joseph will have an expected profit of $2,737 under his assumed probability and is
expected to lose $26,006 at a risk neutral probability.

Recommendations

We recommend that Joseph keep his call options until the end of his 4-year vest given the huge sum of
money he is expected to make.
As for taking up Mark’s offer, Joseph should not take it up at his estimated option value of $5.21. As
seen from the analysis and Table 3, this is not a profitable deal for Joseph. To make alternative
investment decisions on MHP shares, whether with Mark or other investors, Joseph should continue to
use all the resources at his disposal. This will give Joseph the opportunity to learn more about the cost of
the transaction, the value he is receiving, and the range of potential outcomes. In this scenario, Joseph
stands to profit only if the stock option been offered at a $2.61 premium. However, that deal would not
have been profitable for Mark.
The Binomial asset pricing model is relatively easy to calculate and provides transparency in the
performance each year. Computations for multi period calculations gets complicated. Also, Joseph
would require market information for predicting future stock prices. Computer programs like Excel help
in automating the calculations but cannot anticipate future prices.

Attachments

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Table 1: Expected stock price using Joseph’s assumed probability and risk neutral probability.*

*See Table Legend on Page 6.

Table 2: Expected stock option premium using Joseph’s assumed probability and risk neutral probability.

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Table 3: Mark’s Investment Analysis for a 1-year option at $5.21 stock option premium

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Table 4: Mark’s Investment Analysis for a 1-year option at $2.61 stock option premium

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