Question
Clara Corp. is a publicly traded entity. On January 1, 20X3, it is trying to decide whether to grant equity-settled stock options or cash-settled share
Clara Corp. is a publicly traded entity. On January 1, 20X3, it is trying to decide whether to grant equity-settled stock options or cash-settled share appreciation rights (SARs) to its employees. Its bank loan has a debt-to-asset covenant that must be maintained and the board of directors is concerned about the impact these compensation plans will have on this covenant. The directors are considering two alternatives as described below: 1. Grant 20,000 equity-settled stock options to its management team. Relevant information is as follows: The exercise price is $45 per share, which is the same as the share price on the date the options are granted. The options vest three years after the grant date and expire on December 31, 20X9. Any employee that leaves during the vesting period forfeits their options. The fair value of the options on the date of the grant is $2.60 per option. The company expects that 10% of the options will be forfeited throughout the vesting period. The fair value of the options at December 31, 20X3, is expected to be $2.90 each. 2. Grant 20,000 cash-settled SARs to its management team. The benchmark price will be $45. The SARs must be exercised by December 31, 20X5. The same forfeiture rates are expected as for the stock options. The fair value of each SAR at December 31, 20X3, is expected to be $11.00. At December 31, 20X3, the companys year end, Clara is expected to have total debt and asset balances of $160,000 and $300,000, respectively. Required: a) Prepare the journal entries for 20X3 for the stock option alternative. Calculate the forecasted debt-to-asset ratio under this alternative. (3 marks) b) Prepare the journal entries for 20X3 for the SARs alternative. Calculate the forecasted debt-to-asset ratio under this alternative. (3 marks) c) Recommend whether Clara should issue stock options or SARs to its management team. (1 mark)
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