Susan Michaels is evaluating the Burton Tool Company’s common stock and warrants to choose the better investment. The firm’s stock is currently selling for $16 per share; its warrants to purchase three shares of common stock at $15 per share are selling for $8. Ignoring transaction costs, Ms. Michaels has $8,000 to invest. She is quite optimistic with respect to Burton because she believes the firm is about to land a new, large government contract.
a. How many shares of stock and how many warrants can Ms. Michaels purchase?
b. Suppose that Ms. Michaels purchased the stock, held it 1 year, and then sold it for $26 per share. What total gain would she realize, ignoring brokerage fees and taxes?
c. Suppose that Ms. Michaels purchased warrants and held them for 1 year and the market price of the stock increased to $26 per share. Ignoring brokerage fees and taxes, what would be her total gain if the market value of the warrants increased to $35 and she sold out?
d. What benefit, if any, would the warrants provide? Are there any differences in the risk of these two alternative investments? Explain.