Stock Buyback Programs and Stock Option Plans: A Framework

Abstract

Firms often use stock buyback programs as a tool to manage the enterprise risk of corporate stock option plans. We introduce a framework for assessing the merit of this strategy. Using a simple model of the asset portfolio, we examine a leveraged corporation that subsequently adds a stock option plan and then adopts a stock buyback program. We illustrate the interaction between the corporate assets and the managerial influence of the stock option plan, as well as the interaction between corporate debt and the stock buyback program. We show that if the stock option plan results in growth of future cash flows, then the value of limited liability falls, the value of debt rises, and the stock option plan asset is greater than the stock option plan liability. However, if the stock option plan results in increased volatility of future cash flows, then the value of limited liability rises, the value of debt falls, and the worth of the stock option plan asset is zero. Hence, the stock option plan asset is worth less than the stock option plan liability. The framework introduced here features simplicity, scalability, and flexibility regarding risk measures.