Question

Common stock versus warrant investment Personal Finance Problem Susan Michaels is evaluating the Burton Tool Company's common stock and warrants to choose the better investment. The firm's stock is currently selling for $51 per share, its warrants to purchase three shares of common stock at $46 per share are selling for $23. Ignoring transactions costs, Ms. Michaels has $8,600 to invest. She is quite optimistic with respect to Burton because she has certain "inside information about the firm's prospects with respect to a large government contract a. How many shares of stock and how many warrants can Ms. Michaels purchase? b. Suppose Ms. Michaels purchased the stock, held it 1 year, and then sold it for $61 per share. What total gain would she realize, ignoring brokerage fees and taxes? c. Suppose Ms. Michaels purchased warrants and held them for 1 year and the market price of the stock increased to $61 per share. Ignoring brokerage fees and taxes, what would be her total gain if the market value of the warrants increased to $46 and she sold out? d. What benefit, if any, would the warrants provide? Are there any differences in the risk of these two alternative investments? Explain. c. If Ms. Michaels purchased warrants and held them for 1 year and the market price of the stock increased to $61 per share, ignoring brokerage fees and taxes her total gain if the market value of the warrants increased to $46 and she sold out is (Round to the nearest dollar The realized gain expressed as a percentage is»% (Round to one decimal place) d. What benefit, if any, would the warrants provide? Are there any differences in the risk of these two alternative investments? Explain Ms. Michaels would have increased profitability due to the high leverage effect of the warrant, but the potential for gain is accompanied with a higher level of risk Is the above statement true of false? (Select from the drop-down menu)

Answer 1

a) We see that Susan has $8600 to invest.

Share price today=$51

No. of Shares that Susan Can Buy today= 168 Shares

Now, if she purchases warrants worth $8600 therefore no. of warrants that she can but today@$23 =373 Warrants.

b) Assuming she bought the stock @$51. Her Selling Price after 1 year=$61

Gain=$61-$51=$10 per share.

No. of share computed above=168 Shares

Therefore Total Gain =$1680

c) Assuming she bought warrants@$23, now she sells the warrant $46. Therefore Gain per warrant = $23.

Total No. of warrants purchased as computed above = 373 Warrants.

Now Total Gain on sale of Warrants=$8579

d) Warrant is an security which gives the buyer a right to buy the underlying share at a predetermined price called the exercise price until the expiry date.

Warrants are useful when the market price of the underlying share is more than the exercise price of the warrant. It then provides a huge upside potential and can provide the investor a higher rate of return. Contrary if the share price are less than the exercise price of the warrant, then the warrant becomes worthless and lapses on the expiry date. Therefore warrants are riskier alternatives vis a vis purchasing a stock.