Blue Frog Case Study Assignment You’ve taken a management position with Blue Frog, Inc., a restaurant chain that just we

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Blue Frog Case Study Assignment
You’ve taken a management position with Blue Frog, Inc., arestaurant chain that just went public last year. The company’srestaurants specialize in exotic main dishes, using ingredientssuch as alligator, bison, and ostrich. A concern you had going inwas that the restaurant business is very risky. However, after somedue diligence, you discovered a common misperception about therestaurant industry. It is widely thought that 90 percent of newrestaurants close within three years; however, recent evidencesuggests the failure rate is closer to 60 percent over three years.So, it is a risky business, although not as risky as you originallythought.
During your interview process, one of the benefits mentioned wasemployee stock options. Upon signing your employment contract, youreceived options with a strike price of $55 for 10,000 shares ofcompany stock. As is fairly common, your stock options have athree-year vesting period and a 10-year expiration, meaning thatyou cannot exercise the options for a period of three years, andyou lose them if you leave before they vest. After the three-yearvesting period, you can exercise the options at any time. Thus, theemployee stock options are European (and subject to forfeit) forthe first three years and American afterward. Of course, you cannotsell the options, nor can you enter into any sort of hedgingagreement. If you leave the company after the options vest, youmust exercise within 90 days or forfeit any options that are notexercised.
Blue Frogs stock is currently trading at $26.32 per share, aslight increase from the initial offering price last year. Thereare no market-traded options on the company’s stock. Because thecompany has been traded for only about a year, you are reluctant touse the historical returns to estimate the standard deviation ofthe stock’s return. However, you have estimated that the averageannual standard deviation for restaurant company stocks is about 55percent. Because Blue Frogs is a newer restaurant chain, you decideto use a 60 percent standard deviation in your calculations. Thecompany is relatively young, and you expect that all earnings willbe reinvested back into the company for the near future. Therefore,you expect no dividends will be paid for at least the next 10years. A 3-year Treasury note currently has a yield of 2.4 percent,and a 10-year Treasury note has a yield of 3.1 percent.
QUESTIONS
You’re trying to value your options. What minimum value wouldyou assign? What is the maximum value you would assign?
Suppose that, in three years, the company’s stock is trading at$60. At that time, should you keep the options or exercise themimmediately? What are some important determinants in making such adecision?
Your options, like most employee stock options, are nottransferable or tradable. Does this have a significant effect onthe value of the options? Why?
Why do you suppose employee stock options usually have a vestingprovision? Why must they be exercised shortly after you depart thecompany even after they vest?
A controversial practice with employee stock options isrepricing. What happens is that a company experiences a stock pricedecrease, which leaves employee stock options far out of the moneyor “underwater.” In such cases, many companies have “repriced” or“restruck” the options, meaning that the company leaves theoriginal terms of the option intact, but lowers the strike price.Proponents of repricing argue that because the option is veryunlikely to end in the money due to the stock price decline, themotivational force is lost. Opponents argue that repricing is inessence a reward for failure. How do you evaluate thisargument?
How does the possibility of repricing affect the value of anemployee stock option at the time it is granted? As we have seen,much of the volatility in a company’s stock price is due tosystematic or marketwide risks. Such risks are beyond the controlof a company and its employees. What are the implications foremployee stock options? In light of your answer, can you recommendan improvement over traditional employee stock options?