TAILIEUCHUNG - EMPLOYEE STOCK OPTIONS, CORPORATE TAXES, AND DEBT POLICY

The investment portfolio typically has a significant impact on an FHLBank’s total interest rate risk profile. While FHLBanks may manage the interest rate risk of its mortgage assets by combining AMA and MBS, and manage the economic value risk of the entire FHLBank through VaR metrics, it is nonetheless a sound practice to separately measure and control price sensitivity in the investment portfolio with limits for price changes given rate changes. For example, the FHLBank may limit the portfolio’s sensitivity to 10 percent when interest rates change 300 basis points. If a FHLBank has a. | THE JOURNAL OF FINANCE VOL. LIX NO. 4 AUGUST 2004 Employee Stock Options Corporate Taxes and Debt Policy JOHN R. GRAHAM MARK H. LANG and DOUGLAS A. SHACKELFORD ABSTRACT We find that employee stock option deductions lead to large aggregate tax savings for Nasdaq 100 and S P 100 firms and also affect corporate marginal tax rates. For Nasdaq firms including the effect of options reduces the estimated median marginal tax rate from 31 to 5 . For S P firms in contrast option deductions do not affect marginal tax rates to a large degree. Our evidence suggests that option deductions are important nondebt tax shields and that option deductions substitute for interest deductions in corporate capital structure decisions explaining in part why some firms use so little debt. This paper explores the corporate tax implications of compensating employees with nonqualified stock options. Corporations deduct the difference between current market and strike prices when an employee exercises a nonqualified stock option. For option-intensive companies with rising stock prices this deduction can be very large. We focus on the effects of options on the year 2000 marginal tax rates MTRs for Nasdaq 100 and S P 100 firms and the implications for debt Understanding the tax implications of options is increasingly important because the proportion of compensation paid in stock options has soared in recent years. A perspective on the magnitude of options compensation and its increase over time can be gained from papers like the one by Desai 2002 who reports that in 2000 the top five officers of the 150 largest . firms received options with grant values exceeding 16 billion which he estimates is a tenfold increase over the decade. He estimates that proceeds from option exercises averaged 29 of operating cash flows in 2000 up from 10 in 1996. In addition We appreciate excellent research assistance from Courtney Edwards Allison Evans Laura Knudson and Julia Wu and insightful comments .

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