chprobSM_ch25 - Chapter 25 Warrants and Convertibles 25.1 a...

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Chapter 25: Warrants and Convertibles 25.1 a. A warrant is a security that gives its holder the right, but not the obligation, to buy shares of common stock directly from a company at a fixed price for a given period of time. Each warrant specifies the number of shares of stock that the holder can buy, the exercise price, and the expiration date. b. A convertible bond is a bond that may be converted into another form of security, typically common stock, at the option of the holder at a specified price for a specified period of time. 25.2 a. If the stock price is less than the exercise price of the warrant at expiration, the warrant is worthless. Prior to expiration, however, the warrant will have value as long as there is some probability that the stock price will rise above the exercise price in the time remaining until expiration. Therefore, if the stock price is below the exercise price of the warrant, the lower bound on the price of the warrant is zero. b. If the stock price is above the exercise price of the warrant, the warrant must be worth at least the difference between these two prices. If warrants were selling for less than the difference between the current stock price and the exercise price, an investor could earn an arbitrage profit (i.e. an immediate cash inflow) by purchasing warrants, exercising them immediately, and selling the stock. c. If the warrant is selling for more than the stock, it would be cheaper to purchase the stock than to purchase the warrant, which gives its owner the right to buy the stock. Therefore, an upper bound on the price of any warrant is the firm’s current stock price. 25.3 a. The primary difference between warrants and call options is that, when warrants are exercised, the firm issues new shares. Both the purchase price and the exercise price of a warrant are received by the firm and increase the value of its assets. Unless a firm is selling calls on its own shares, this does not hold true for options. b. When call options are exercised, the number of shares the firm has outstanding remains unchanged. Shares of the company’s stock are simply transferred from one individual to another. When warrants are exercised, however, the number of shares outstanding increases. This results in the value of the firm being spread out over a larger number of shares, often leading to a decrease in value of each individual share. The decrease in the per-share price of a company’s stock due to a greater number of shares outstanding is known as dilution . 25.4 a. Before the warrant was issued, Survivor’s assets were worth $3,500 (= 7 oz of platinum * $500 per oz). Since there are only two shares of common stock outstanding, each share is worth $1,750 (= $3,500 / 2 shares). b. When the warrant was issued, the firm received $500 from Tina, increasing the total value of the firm’s assets to $4,000 (= $3,500 + $500). If the two shares of common stock were the only outstanding claims on the firm’s assets, each share would be worth $2,000 (= $4,000 / 2 shares). However, since the warrant gives Tina a claim on the firm’s assets worth $500, the value of the firm’s assets available to stockholders is only $3,500 (= $4,000 - $500).
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