Common stock versus warrant investment Tom Baldwin can invest $6,300 in the comm

Question

Common stock versus warrant investment Tom Baldwin can invest $6,300 in the common stock or the warrants Lexington Life Insurance. The common stock is currently selling for $30 per share. Its warrants, which provide for the purchase of two shares of common stock at $28 per share, are currently selling for $7. The stock expected to rise to a market price of $32 within the next year, so the expected theoretical value of a warrant over the next year is $8. The expiration date of the warrant is 1 year from the present. If Mr. Baldwin purchases the stock, holds it for 1 year, and then sells it for $32, what is his total gain? (Ignore brokerage fees and taxes.) If Mr. Baldwin purchases the warrants and converts them to common stock in 1 year, what is his total gain if the market price of common shares is actually $32? (Ignore brokerage fees and taxes.) Repeat parts a and b, assuming that the market price of the stock in 1 year is $30 and $28. Discuss the two alternatives and the trade-offs associated with them.

Explanation / Answer

a.

No. of shares repurchased = $6,300 / $30 per share = 210 shares

Gain per share = $32 - $30 = $2 per share

Total gain = 210 shares * $2 = $420

Gain percentage = $420/$6,300 = 6.67%

b.

No. of warrants purchased = $6,300 / $7 per warrant = 900 warrants

Profit on original investment = ($4 per share * 2) – $7 price of warrant = $1

Total profit = $1 * 900 warrants = $900

Gain percentage = $1 / $7 = 14.29%

c.

Stock

(1) $6,300 investment – $6,300 proceeds from sale = $0

(2) 210 shares * ($28 – $30) = – $420 = (–6.67%)

Warrants

(1) [($2 gain per share * 2 shares) – $7 price of warrant] * 900 warrants = –$3 * 900 = –$2,700 = –42.85%

(2) Since the warrant exercise price and the stock price are the same, there is no reason to exercise the warrant. The full investment in the warrant is lost:

$7 * 900 warrants = $6,300

– $7 / $7 = –100%

d.

Warrants increase the possibility for gain and loss. The leverage associated with warrants results in higher risk as well as higher expected returns.

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.