Harmer Inc. is now a successful company. In the early days (before it became profitable), it issued ISOs to its employees. Now Harmer is trying to decide whether to issue NQOs or ISOs to its employees. Initially, Harmer would like to give each employee 20 options (each option allows the employee to acquire one share of Harmer stock). For purposes of this problem, assume that the options are exercised in three years (three years from now) and that the underlying stock is sold in five years (five years from now). Assume that taxes are paid at the same time the income generating the tax is recognized. Also assume the following facts:

• The after-tax discount rate for both Harmer Inc. and its employees is 10 percent.

• Corporate tax rate is 35 percent.

• Personal (employee) ordinary income rate is 40 percent.

• Personal (employee) long-term capital gains rate is 20 percent.

• Exercise price of the options is $7.

• Market price of Harmer at date of grant is $5.

• Market price of Harmer at date of exercise is $25.

• Market price of Harmer at date of sale is $35.

Answer the following questions:

a) Considering these facts, which type of option plan, NQO or ISO, should Harmer Inc. prefer? Explain.

b) Assuming Harmer issues NQOs, what is Harmer’s tax benefit from the options for each employee in the year each employee exercises the NQOs?

c) Assuming Harmer issues ISOs, what is the tax benefit to Harmer in the year the ISOs are exercised?

d) Which type of option plan should Harmer’s employees prefer?

e) What is the present value of each employee’s after-tax cash flows from year 1 through year 5 if the employees receive ISOs?

f) What is the present value of each employee’s after-tax cash flows from year 1 through year 5 if the employees receive NQOs?

g) How many NQOs would Harmer have to grant to keep its employees indifferent between NQOs and 20 ISOs?