1. University of Montana - September 15, 2006 Repurchases, Employee Stock Option Grants, and Hedging Daniel A. Rogers Portland State University

2. Elevator pitch What’s the rationale for observed relation between employee options and stock repurchases? Partial explanation: repurchases serve as hedge against uncertainty surrounding option obligations. Provides more “economic” justification than EPS management hypothesis. Findings: Employee stock option grants exhibit positive relation with repurchases. For firms in which this relation is strongest, I find evidence consistent with an optimal hedging motive (although there might be more to the story.

3. Background on options and repurchases Microsoft: “We repurchase our common shares primarily to manage the dilutive effects of our stock option and stock purchase plans, and other issuances of common shares.” - 2003 10-K Footnote 14 to financial statements. Existing empirical evidence Substitution of repurchases vs. dividends (exec story): Fenn and Liang (2001 JFE) and Kahle (2002 JFE). Option funding: Kahle (2002 JFE). Earnings management (anti-dilution): Bens et al. (2003 JAE) and Weisbenner (2000 wp).

4. Another Story? Granting options to employees creates uncertain future liability for shareholders. Current shareholders incur an opportunity cost when employee stock options are exercised. Amount of the opportunity cost = (stock price at exercise date – exercise price). Do shareholders hedge this uncertainty? Hedging strategy: repurchase shares when options are granted. Similar to a forward purchase of currency or commodity. Strategy implies positive relation between repurchases and option grants over time.

5. Example Assume: Stock price = $20; Option granted at the money; Cost of equity = 8%; and Dividend yield = 3% What is the ultimate cost borne by existing shareholders? Exercise price at time of exercise – grant date price Suppose exercise occurs in 5 years: FV of $20 invested in 5 years = $25.68 ($20 * 1.05 5 ) Ex post economic cost = $5.68 if repurchase (known at time of grant and repurchase) Ex post economic cost = ??? if no repurchase

6. How does situation differ from other hedging problems? Typical hedging situation: “bad” outcomes = low cash flows or earnings. In this case: “bad” outcome is high stock price at time of exercise. “Normal” opportunity cost: stock price increases by dividend-adjusted cost of equity. If stock price change between grant and exercise dates exceeds dividend-adjusted cost of equity, repurchasing stock at grant date provides a positive payoff against excess opportunity cost.

7. Why might a high stock price be bad? Jensen (2005) arguments Management “games” market expectations  stock price > intrinsic value Wealth-destroying acquisitions (Moeller et al., 2005 JF) Employees choose when to exercise: If employees exercise options when price is above intrinsic value  rent extraction. If company repurchases stock at high prices, its alternatives to fund growth opportunities are 1) less investment, 2) tap external capital markets

8. What are the “traditional” incentives to hedge? Reduction of underinvestment/distress costs Froot et al. (1993), Tufano (1998), Smith and Stulz (1985), among others. Tax function convexity Smith and Stulz (1985) Increase borrowing capacity and interest tax shields Leland (1998) Managerial motives Smith and Stulz (1985), Stulz (1984), Tufano (1996), among others.

9. Does the option hedging story fit into any of these categories? Reduction of distress and tax convexity? Clearly, NO! Increasing debt tax shields? Maybe Mozes and Raymar (2001 wp): issue options, issue debt and repurchase stock. Managerial motives? Hard to disentangle hedging motive from “underpriced stock” story.

10. What about the underinvestment theory? If assume firm monetizes opportunity cost by repurchasing shares around option exercise, then: Higher stock price  less cash available for investment at exercise date. If deadweight costs associated with new (debt) financing, then firm might underinvest. Repurchasing stock at grant date is effective if investment opportunities are correlated with stock price (this idea seems reasonable).

11. Plan of attack First, establish if a link exists between option grants and stock repurchases. Regress stock repurchases on option grants and other explanatory variables. If a link exists, then can optimal hedging story explain hedging behavior? Construct a measure of “hedging” and regress optimal hedging proxy variables against it.

12. Sample 151 randomly selected S&P 500 firms. Manual data collection of employee option data. Time frame: 1993 – 2003 (or maximum 10-K filings available from EDGAR).

13. Research design - Option grants & repurchases Dependent variable = number of shares repurchased Independent variables: log of market capitalization free cash flow market-to-book of assets capital expenditures long-term debt dividend yield stock price change stock price volatility option grants  this is the variable of interest! exercised options

14. Data summary MeanMedianStd Dev Repurchases1.83%0.69%2.83% Option grants2.23%1.56%2.91% Rep / grants2.420.3618.87 Exercises1.08%0.70%1.37% Total options8.10%6.93%6.84% Vested options4.06%3.39%3.34% Exec options1.65%1.24%1.79% Vested exec options 0.90%0.60%1.08%

15. Methodological issues Dependent variable is censored at zero (approximately 1/3 of observations) Suggests Tobit methodology Panel data Random/fixed effects Fixed effects model in Tobit would yield biased estimates. Tobit random effects estimation

16. Key results – Base repurchases model (Table 2) Repurchases and options: Positive relation with option grants and exercises. Robust to inclusion of other option variables (Panel B). Other option variables do not exhibit similar statistical relations with repurchases (Panel B). Repurchases and other variables: Positive relations with: Firm size, and free cash flow. Negative relations with: Market-to-book, leverage, current year stock price change and volatility.

17. Robustness results – Table 3 “Excess” grants are positively related to repurchases (two- stage model). Controlling for lagged option grants back 4 years. Concurrent grants remain positively related to repurchases. Evidence of stronger relations for 1 and 2-year lagged grants. Controlling for Bens et al. (2003) earnings management variables. Option grants remain positively related to repurchases.

18. How Is Hedging Defined? Cannot directly observe “hedging” from disclosures. Derived measure: Coefficient of variation for repurchases-to- grants ratio = inverse hedging measure. Effectively captures a population driving positive relation between grants and repurchases in multivariate.

19. Coefficient of variation and mean: Repurchases-to-grants ratio Full sample = 140 firms (at least 1 yr of repurchases) Coefficient of variationMean Average1.582.64 Median1.401.13 Standard deviation0.736.17 25 th percentile1.020.50 75 th percentile2.052.38 Minimum0.240.01 Maximum3.3257.67

20. What variables explain option grant hedging? Table 5 – differences between models Model 1: no industry controls Model 2: industry controls, but no control for variation of repurchases-to- exercises Model 3: includes variation of repurchases-to-exercises, but no industry controls Model 4: Controls for variation of repurchases-to-exercises and industry effects Model 4 results - Effect on “hedging”: Leverage: Negative relation R&D expenditures: Positive relation Vested exec options: Positive relation Firm size: Negative relation Market-to-book: Negative relation Exec shares held: Positive relation

21. What about the “non-hedgers?” Table 6 results Difference between non-repurchasing firms vs. those that repurchase (logit) Lower free cash flow Greater leverage More R&D “Continuous” measure of option grant hedging Very similar results relative to Table 5

22. Summary of Most Notable Results Option grants are positively related to repurchase activity. Even if not intentional, this pattern provides a hedge for shareholders against uncertain opportunity cost of options. Firms that exhibit less variation in repurchase activity relative to option grants also exhibit greater R&D spending and less leverage. This set of results fits underinvestment costs rationale for hedging.