Letter Sent to Forbes

Dear Mr. Rich,

I read your piece in Forbes on stock options with great interest, in which you offer your version of the economic cost of stock options to a company. I have a variation on this theme and would appreciate your comments.

Assume company A buys company B for $1 million. Company B's has only one asset, a brand new machine with a 10 year useful life. Company A settles the deal with its stock that has a market value of $1 million at date of closing. The journal entry is simply: Debit Machine and Credit Equity with the transaction value of $1 million. For the next ten years company A will recognize a depreciation expense of $100,000. The economic cost of using the machine is determined relative to the market value of the stock issued to acquire the machine.

Now, assume company A hires the services of person C. Company A compensates C, by granting C 10,000 options with a strike price of $5 and exercisable during the next five years. C exercises the option in year 3 when the stock price is $25. The economic cost to company A is $200,000 ($25 less $5 times 10,000). Because the IRS grants company A a notional deduction of $200,000, the after-tax cost to company A is $130,000, assuming a corporate tax rate of 35%. What can be more straight-forward than this and consistent with the previous example in which stock was offered to buy a machine? What am I missing?

Albert Meyer