P17-19 Common stock versus warrant investment

Tom Baldwin can invest $3,000 in the common stock or the warrants of Lexington Life Insurance. The common stock is currently selling for $45 per share. Itswarrants, which provide for the purchase of 5 shares of common stock at $40 pershare, are currently selling for $28. The stock is expected to rise to a market price of $50 within the nextyear, so the expected theoretical value of a warrant over the next year is $50. The expiration date of the warrant is 1 year from the present.

a.If Mr. Baldwin purchases thestock, holds it for 1year, and then sells it for $50, what is his totalgain? (Ignore brokerage fees andtaxes.)

b.If Mr. Baldwin purchases the warrants and converts them to common stock in 1year, what is his total gain if the market price of common shares is actually $50? (Ignore brokerage fees andtaxes.)

c.Repeat parts a and b, assuming that the market price of the stock in 1 year is $45.

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