Expected Utility Valuation of Executive Stock Options in a Binomial Framework : A Comparative Analysis

Options are among the most important forms of compensation and incentive structuring. Standard option pricing theory provides guidelines but not a conclusive prescription of how to value executive stock options. Academic research on this subject has gone in several related but distinct directions. This paper examines one thread of this research stream: binomial models based on expected utility. We start by illustrating the procedures for estimating executive option values using expected utility analysis in a binomial framework. Using a common set of inputs based on reasonable empirical data, we compare option values and company costs based on differences in inputs and assumptions. Our findings identify variables that are important and others with relatively minor impact. We also examine the effect of dividends on executive stock options values, a topic that has been largely ignored to date. We discuss how standard procedures contain certain computational inconsistencies that result in confusion over the true values or costs. We also note that the typical assumption that company cost is not executive value further reinforces this confusion and is quite likely to be incorrect