Question

Common stock versus warrant investment: Personal Finance Problem   Tom Baldwin can invest​ $5,000 in the common stock or the warrants of Lexington Life Insurance. The common stock is currently selling for ​$50 per share. Its​ warrants, which provide for the purchase of 4 shares of common stock at ​$46 per​ share, are currently selling for ​$20. The stock is expected to rise to a market price of ​$52 within the next​ year, so the expected theoretical value of a warrant over the next year is ​$24. The expiration date of the warrant is 1 year from the present.

a. If Mr. Baldwin purchases the​ stock, holds it for 1​ year, and then sells it for ​$52​, what is his total​ gain? ​ (Ignore brokerage fees and​ taxes.)

b. 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 ​$52? ​ (Ignore brokerage fees and​ taxes.)

c. Repeat parts a and b​, assuming that the market price of the stock in 1 year is ​$47.

d. Discuss the two alternatives and the​ trade-offs associated with them.

Answer 1

Solution :-

(A)

Total gain on holding a share for 1 year and selling it off after that period =

Total Gain = [ Amount Invested / Stock Price per share ] * [ Selling Price Per Share - Purchase Price Per Share ]

= [ $5,000 / $50 ] * [ $52 - $50 ]

= $200

(B)

Total Gain After Conversion from Warrant

Number of Warrants Purchased = $5,000 / $20 = 250

Difference in Stock Price = ( Current Market Per Share - Purchase Price Per Share )

= ( $52 - $46 )

= $6

With one warrant Shares Purchased = 4

Total Earnings = $6 * 4 = $24

Gain from one Warrant = Current Value of Warrant - Purchase Price = $24 - $20 = $4

Total Gain = $4 * 250 = $1,000

(C)

If Market price of share = $47

Total gainfrom Selling Shares = $0

Total gain / loss on Common Stock after Conversion from warrant at stock price = $47

Total Loss = $47 * 250 = $11,750

(D)

From the above it clear that warrant gives higher return if the movement in the stock price is as per investors

Warrant increase the loss probability . The Return from investment is high in warrant when it is compared to stocks because of the warrant leverage effect

Warrant is more risky and gives higher return too when compared to stock prices

If there is any doubt please ask in comments