Chapter 20, Problem 6P

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

Chapter
Section

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

# WARRANTS Potter Industries Inc. ha?, warrants outstanding that permit its holders to purchase 1 share of stock per warrant at a price of $18. (Refer to Chapter 18 for parts a, b, and c.) a. Calculate the exercise value of Potter's warrants if the common stock sells at each of the following prices:$18, $21,$25, and $70. b. At what approximate price do you think the warrants would sell under each condition indicated in part a? What premium is implied in your price? Your answer will be a guess, but your prices and premiums should bear reasonable relationships to each other. c. How would each of the following factors affect your estimates of the warrants' prices and premiums in part b? 1. The life of the warrant is lengthened. 2. The expected variability (σp) in the stock’s price decreases. 3. The expected growth rate in the stock’s EPS increases. 4. The company announces the following change in dividend policy: Whereas it formerly paid no dividends, henceforth it will pay out all earnings as dividends. d. Assume that Potter's stock now sells for$18 per share. The company wants to sell some 20-year, annual interest, $1,000 par value bonds. Each bond will leave 25 warrants, and each warrant entitles the holder to buy 1 share of stock at a price of$21. Potter’s straight debt yields 10%. Regardless of your answer to part b, assume that the warrants will have a market value of $1.75 when the stock sells at$18. What annual coupon interest rate and annual dollar coupon must the company set on the bonds with warrants if foe Kinds are to clear the market (i.e., the market is in equilibrium)? Round to foe nearest dollar or percentage point.

a.

Summary Introduction

To Determine: The exercise value of Company PII’s warrants if the common stock sells at $18,$21, $25 and$70.

Introduction: A warrant is securities that give the bondholder the right, yet not the obligation, to purchase a specific number of securities at a specific cost before a specific time. Warrants are not the equivalent as the call options or purchase rights of the stock.

Explanation

Determine the exercise value of company PIIās warrants

If the common stock sells at $18 ExerciseāPriceIfāStockāPriceāisā$18=[CurrentāPriceāStrikeāPrice]=[$18ā$18]=$0 If the common stock sells at$21

ExerciseāPriceIfāStockāPriceāisā$21=[CurrentāPriceāStrikeāPrice]=[$21ā$18]=$3

If the common stock sells at \$25

<

b.

Summary Introduction

To Determine: The approximate price and the premium implied the warrants to sell under each condition from part (a) based on guess or reasonable assumption.

c.

Summary Introduction

To Determine: The factors that affect the estimates of the warrants' prices and premium in part b when the (1) the life of warrant in lengthened, (2) the expected variability in stock's price decrease, (3) the growth rate in the stock's EPS increase and (4) when the company paid no dividends and will pay out all earnings as dividends.

d.

Summary Introduction

To Determine: The annual coupon interest rate and annual dollar coupon on the bonds.

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