Blue Frog Case Study Assignment

Youve taken a management position with Blue Frog, Inc., a restaurant chain that just wentpublic last year. The companys restaurants specialize in exotic main dishes, using ingredientssuch as alligator, bison, and ostrich. A concern you had going in was that the restaurantbusiness is very risky. However, after some due diligence, you discovered a commonmisperception about the restaurant industry. It is widely thought that 90 percent of newrestaurants close within three years; however, recent evidence suggests the failure rate iscloser to 60 percent over three years. So, it is a risky business, although not as risky as youoriginally thought.

During your interview process, one of the benefits mentioned was employee stock options.Upon signing your employment contract, you received options with a strike price of $55 for10,000 shares of company stock. As is fairly common, your stock options have a three-yearvesting period and a 10-year expiration, meaning that you cannot exercise the options for aperiod of three years, and you lose them if you leave before they vest. After the three-yearvesting period, you can exercise the options at any time. Thus, the employee stock optionsare European (and subject to forfeit) for the first three years and American afterward. Ofcourse, you cannot sell the options, nor can you enter into any sort of hedging agreement. Ifyou leave the company after the options vest, you must exercise within 90 days or forfeit anyoptions that are not exercised.

Blue Frogs stock is currently trading at $26.32 per share, a slight increase from the initialoffering price last year. There are no market-traded options on the companys stock. Becausethe company has been traded for only about a year, you are reluctant to use the historicalreturns to estimate the standard deviation of the stocks return. However, you haveestimated that the average annual standard deviation for restaurant company stocks is about55 percent. Because Blue Frogs is a newer restaurant chain, you decide to use a 60 percentstandard deviation in your calculations. The company is relatively young, and you expect thatall earnings will be reinvested back into the company for the near future. Therefore, youexpect no dividends will be paid for at least the next 10 years. A 3-year Treasury note currentlyhas a yield of 2.4 percent, and a 10-year Treasury note has a yield of 3.1 percent.

QUESTIONS

1. Youre trying to value your options. What minimum value would you assign? What isthe maximum value you would assign?