Question

Quantitative Problem 3: A warrant is a long-term option from a company that gives the holder the right to buy a stated number of shares of the firm's stock at a specified price for a specified length of time. Generally, warrants are distributed with debt, and they are used to induce investors to buy long- term debt that carries a lower coupon rate than would otherwise be required. The exercise of warrants brings in additional funds to the firm. A corporation decides to issue 10-year bonds to fund a necessary expansion. If they were straight bonds, they would carry a 10% annual coupon. However, the bonds with warrants can be sold with a 9% coupon. Thus, investors would be paying $1,000 in return for the 9% coupon, 10-year bond and 20 warrants. Suppose that the warrants expire in 5 years, and the exercise price on the warrants is $11. (Remember that each bond includes 20 warrants.) The firm's current stock price is $8.00, but the price is expected to grow by 15% per year. Assuming that the warrants will not be exercised prior to expiration, what is the overall rate of return to investors? Do not round intermediate calculations. Round your answer to one decimal place.

Answer 1

A-3

Interest Received each year	$90.00	=1000*9%
Current Srock Price	$8.00
Stock price after 5 years	$16.09	=8*((1+15%)^5)
Exercise Price on Warrant	$11.00
Gain on each warrant	$5.09	=16.09-11
No. of Warrants	20
Total Gain on warrants	$101.82	=5.09*20
Average Gain on warrants for 5 years	$20.36	=101.82/5
Total average Rerurn each year	$110.36	=90+20.36
Overall Rate of Return to Investors	11.04%

A-1

Annual coupon of straight bonds	8%
Price of such bond	$800
Price of 7% coupon Bonds	$700	=800/8%*7%

A-2

Coupon Received for Straight Bonds	$110	=1100*10%
Coupon Received for Bonds with warrants	$99	=1100*9%
Coupon sacrificed for Warrants for 1 year	$11	=110-99
No. of years	10
Total Value of Warrants	$110	=11*10
No. of Warrants per Bond	17
Value of each warrant	$6.47	=110/17