Question

Common stock versus warrant investment Personal Finance Problem Tom Baldwin can invest $7,000

in the common stock or the warrants of Lexington Life Insurance. The common stock is currently selling for $55

per share. Its​ warrants, which provide for the purchase of 2 shares of common stock at $49 per​ share, are currently selling for $15.

The stock is expected to rise to a market price of $61 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 $61​, 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

​$61​.​ (Ignore brokerage fees and​ taxes.)

c.Repeat parts a and b​, assuming that the market price of the stock in 1 year is $55.

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

Answer 1

Ans.

a. If Mr. Baldwin purchases the​ stock, holds it for 1​ year, and then sells it for $61​, what is his total​ gain?

Number of shares purchased = $ 7,000 / $ 55 = 127.2727 or 127 shares

Price change in share = $ 61 - $ 55 = $ 6

Total Gain = 127 * 6 = $ 762

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 $61​.​ (Ignore brokerage fees and​ taxes.)

Number of warrants purchased = $ 7,000 / $ 15 = 466.6667 or 467

Price change in share = $ 61 - $ 55 = $ 6

Warrants to shares = 467 * 2 = 934

Total Gain = 467 * 6 = $ 2,802

c.Repeat parts a and b​, assuming that the market price of the stock in 1 year is $55.

Stock Price = $ 55

Price change in share = $ 55 - $ 55 = $ 0

Part a ) Total Gain = $0

Part b) Total Gain = $0

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

If we purchase warrants  the possibility of both gain and loss increases.

So, if we investing in warrants it provides a higher risk along with the expectation of higher returns.