Stock vs. Warrants: Investment Analysis for Mr. Baldwin
What are the potential gains for Mr. Baldwin if he invests in the common stock or warrants of Lexington Life Insurance? What are the trade-offs associated with each investment option?
Stock investment gain: $750 ([$50 - $45] * 3 shares). Warrant investment gain: $150 ([$50 - $39] * 3 shares). Stock investment gain: $0 ([$44 - $45] * 3 shares). Stock: Lower risk, guaranteed gain in a favorable market; Warrants: Higher risk, potentially higher return if the market performs well. Trade-off: risk vs. potential gain.a. Stock Investment Gain
b. Warrant Investment Gain
c. Different Market Price Scenario
d. Trade-offs
Explanation:
a. If Mr. Baldwin purchases the stock at $45 per share, holds it for 1 year, and then sells it for $50 per share, he gains $750 in total. This is calculated as the difference between the selling price and the purchase price ($50 - $45) multiplied by the number of shares (3 shares).
b. If Mr. Baldwin purchases the warrants at $20 and converts them to common stock at $39 per share in 1 year, and the market price of common shares is $50 at that time, he gains $150 in total. This is calculated as the difference between the market price of the common stock and the warrant conversion price ($50 - $39) multiplied by the number of shares (3 shares).
c. If the market price of the stock in 1 year is $44, there is no gain for Mr. Baldwin. This is because the market price of the stock is below the purchase price of $45, resulting in a loss of ($44 - $45) * 3 shares = -$3.
Trade-offs:
Stock investment is less risky as it offers a guaranteed gain when the market price rises, while warrants are riskier due to their speculative nature.
Warrants have the potential for higher returns if the market performs well, but they can also lead to losses if the market price doesn't reach the expected level.
Choosing stock provides a more stable and predictable outcome, while warrants have higher uncertainty and require careful market prediction. Mr. Baldwin must weigh risk tolerance and market expectations to make an informed decision.