WARRANTS

Potter Industries Inc. has 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 (σ) 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 have 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 the bonds are to clear the market (i.e., the market is in equilibrium)? Round to the nearest dollar or percentage point.

A. The exercise value of Potter's warrants if the common stock sells at $18 is $0. If the common stock sells at $21, the exercise value of the warrant is $3.

If the common stock sells at $25, the exercise value of the warrant is $7. If the common stock sells at $70, the exercise value of the warrant is $52.
B. If the stock sells at $18, the warrants would have no value. If the stock sells at $21, the warrants might sell for around $2.50 to $3, which is the premium over the exercise value. If the stock sells at $25, the warrants might sell for around $7.50 to $8, which is the premium over the exercise value. If the stock sells at $70, the warrants might sell for around $52 to $53, which is the premium over the exercise value.
C. 1. If the life of the warrant is lengthened, the warrants' prices and premiums will increase
2. If the expected variability in the stock's price decreases, the warrants' prices and premiums will decrease.
If the expected growth rate in the stock's EPS increases, the warrants'
prices and premiums will increase. If the company announces a change in dividend policy, the warrants' prices and premiums may or may not be affected, depending on the specifics of the new policy.
D. The annual coupon interest rate on the bonds with warrants must be $70 and the annual dollar coupon must be $70.72 if the bonds are to clear the market. This assumes a 10% yield on Potter's straight debt and a market value of $1.75 for the warrants when the stock sells at $18.

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