Question

Assess the value of warrants, options, hedge instruments, and the methods of pricing a new equity issue describing what key factors are requisite to launch a successful new stock.

Answer 1

Warrants are generally associated with bonds and preferred stock. These warrants are also sometimes referred to as dividends. Warrants generally allow the convertible bond holders to buy a stock in exchange for the bond.

Options are derivatives that allow an investor to buy or sell the underlying stock. Its gives the investor a right, but not an obligation to buy/sell the stock based on the prevailing price of the stock on the expiry date. It can be used as an hedging instrument in covering risk.

Other hedging instruments are futures and forwards contracts. Both of them are the same, except that there an intermediary in form of an exchange in futures contracts. Both of them gives give the buyers a fixed rate of exchange at a future point of time. In these cases, there will be no fluctuation of company profits based on currency movement.

Methods of pricing a new equity - This involves valuation of the company by several independent and external agencies so as to accurately arrive at a stock price for the equity issue. The various valuation methods for pricing new equity would be: Discount cash flow method (DCF), a leveraged buyout method (LBO), Comparable analysis and Precedent transaction analysis.

Key factors to launch a successful IPO (Initial public offering):

1. The under pricing: Most new IPO's under-price their stock so that more people subscribe to the new issue. The actual price is obtained by the demand and supply at the end of day 1 on the stock market.

2. The underwriting costs: The IPOs should try to reduce the underwriting costs, the costs that is required to be paid for the registrar or underwriter for the new equity issue

3. Legal costs: The IPO's should reduce their legal costs involved in fresh equity issue so as to make the overall floatation cost of equity lower thereby making their stock look attractive.