When company options are exercised...

When company options are exercised, does the exercise price of option goes to the company? See below question. Assume that the exercise price of an option is $5, and the average market price of the stock is $8. Assuming 816 options are outstanding during the entire year, what is the number of shares to be added to the denominator of the diluted EPS? A) 306. B) 510. C) 816. Your answer: C was incorrect. The correct answer was A) 306. (816)(5) = $4,080. $4,080 / $8 = 510 shares. 816 − 510 = 306 new shares or [(8 − 5) / 8]816 = 306.

I’m pretty sure this is the method one should use when warrants are outstanding, but I’m not sure if it is different for options…

I am not sure I understand your question correctly, but I will make it easier for you to understand. Warrants and options are basically same. Let’s say you hire a stock-picker from your competitor. He’s so valuable to your firm that you do not want to lose him, but do not want to pay him too much as it’s all depends on his picks. So, you give him stock options. Beginning of the year, you gave him 816 options at the exercise price of $5. Now, he has incentive to work harder to exercise those options, so he can make some money. During the year, stocks that he picked performed very well, and the average market price of your company is $8. Now, his options are in the money and he’s ready to exercise his options. He has a right to purchase stocks at $5 for 816 stocks ($4080) and possible can sell his stocks at $8 ( make profit of ($2448). However, who’s losing $2448 here? Basically, your company paid for the difference between the market price and the exercise price. The difference between $6528 (816*8) and 4080 (816*5) will be $2448, and 306 shares should be issued to pay the difference. ($2448/8)= 306. There is a formula to calculate this as well. I am pretty sure you already know this. (average market price-exercise price)/exercise price * number of options (8-5)/8 * 816= 306 You can use this formula to get the answer very fast and easy, but I think understanding the logic will be useful for long-term. Hope it makes sense.


When options are exercised, company issues new shares. Now employees will give the company a total of 5*816 dollars ie $4080. But 4080 dollars cannot buy 816 shares worht $8 each, so the company has to raise more money to cover the $3 per stock. So the company issues new stock equivalent to the (8-5)*816. Now this money can create only 306 stocks @ $8 per share.

When employees exercise the Option they selll the shares, in this case 816 shares @$8, as that is the Market price. When employees are selling, company has to buy. So, effectively, company has to buy the shares from the employee at the rate of $8. But remember, employees need money, not share, so they will get their money from the company. So, company had to spend $6528, but company has already $4080 with it. Thus, company needs $2448 more. How company will generate this money, by issuing ($2448/8) 306 shares. Means, only 306 shares will be added to the pool of Common Stock. But my question is, who will buy these 306 stocks from company @$8, is company issuing the stock in the market and getting the money from market? If that be the case, can a company issue new common stock at market price? If it happens, the BV of Common Stock also will be affected, won’t it be? Pls clarify. Many thanks in advance.

This treasury stock method is a requirement under GAAP when calculating diluted EPS. In real life, this might not happen at all. You can think of it this way. Holders exercise their options/warrants at @$5. They immediately sell to the market @ $8. Company who got the funds via the options/warrants will repurchase their shares from the market @ $8. They can only repurchase 306 shares using the funds in this case.