Question

The corporation you work for needs financing. It could issue warrants, sell stock or bonds to finance the firm. Several issues confront you as an analyst. The firm currently has 1 million shares of stock outstanding. The warrants, if issued, will be for rights on 200,000 shares of stock. The strike price on the warrants will be $30.00 per share, time to expiration will be 5 years, stock price, prior to announcement is $50, the stock price may increase or decrease by 25% over the next five years, the continuous annual risk-free interest rate is 3% per year, the standard deviation of stock returns is 20% per year. After the announcement that you will be issuing the warrants the stock price drops to $40.00 per share. Your uptick and downtick expectations have not been altered by the stock price decline.

A. What is the pre-announcement funds that the firm could hope to raise through the sale of the warrants (ignoring transactions costs).

B. What is the post announcement funds that the firm could hope to raise through the sale of the warrants (ignoring transactions costs).

C. Why do A and B differ due the fact that investors will adjust downward the current stock price by the amount of the expected dilution?

D Which of the three possible issuances (warrants, stock, bonds) will be likely to have the greatest negative effect on stock price?

Answer 1

Greetings,

a) Share price before announcement is 50. So difference between strike price and share price is 20. So amount expected to be raised through warrants = 200000×20 = 40 lacs

b) Share price after announcement is 40. So difference between strike price and share price is 10. So amount expected to be raised through warrants = 200000×10 = 20 lacs

c) A and B got to differ as stock price will fall definitely as share worth 50 is sold for 20 before announcement. So company's market cap will increase at lower rate such that per share value will fall.

d) Stock warrants are most dilutive in terms of share price as they are issues at concessional price while equity is issued at MV. Bonds do not have much effect on share price apparently, although due to higher debt risk of company increase and share price may fall.