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In addition to the traditional equity investments
like common and preferred stocks, there are other type of investments vehicles
which are similar to equities but are not true equities. Like all
investment vehicles, each of these has its advantages and its disadvantages.
These vehicles include:
When a company issues additional shares of stock, its exsting shareholders
run the risk of having their ownership "diluted."
In order to help their shareholders maintain their ownership percentage,
some companies give their existing shareholders subscription
rights whenever they issue new shares of stock.
These subscription rights allow existing shareholders to purchase additional
shares of the company at a lower price than the one at which the new shares
will be offered to the general public. Whether a given company issues
subscription rights when it has a new stock offering, is usually specified
in the corporation's charter. Investors generally consider the stocks of
companies that offer subscription rights to be more attractive than the
stocks of companies that do not, all other factors being equal.
For example, if company XYZ currently has 1,000,000 shares of stock
outstanding and person A owns 100,000 of thise shares, A effectively owns
10% of XYZ. However, if XYZ issues another 200,000 shares of common stock,
then to retain her 10% interest, A will have to buy another 20,000 shares
of XYZ. If A chooses not to purchase any additional shares, her ownership
percentage would be diluted after the offering to 8.3% [(100,000/1,200,000)
If the investors do not wish to purchase any additional
shares of the corporation, they can still generate a return from their
rights by selling their rights in the open market. After all, these rights
have value since they entitle holders to buy stock at a discounted price.
For example, if company XYZ is trading for $100
a share when the company announces that it will be selling the additional
200,000 shares. As part of this stock offering, XYZ will give their existing
share holders one subscription right for every share each shareholder already
owns. For every five subscription rights an investor receives, s/he is
able to purchase one additional share of stock for $70 per share instead
of the public offering price of $100 per share.
is a security that entitles its owner to buy a share of the issuing company's
stock at a predetermined price - regardlessof the current market value
of the stock. If the stock's market value is higher than the warrant's
predetermined price, then the investor can generate an immediate profit.
By using the warrant to buy the stock from the company at a predtermined
price and then selling the stock at the higher current market price, the
investor makes a profit. The market value of the warrant is composed of
two components: the intrinsic value and the premium.
If the value of the warrant is valued at $10 and the market price of that
share of stock is $2, the investor would have made a profit of $15. Then
we can say that the warrant has $15 worth of intrinsic value, or
immediately realizable value.
The difference between the market value of the warrant and its intrinsic
value is the premium. Thus, if the XYZ warrants were trading
in the open market at $17.50 each, the price would consist of $15 of intrinsic
value and $2.50 of premium or a premium of 16.67%. Investors are usually
willing to pay a premium in order to buy warrants because warrants enable
buyers to obtain higher percentages of return than possible by buying the
For example, person A has a choice of buying either XYZ warrants for
$17.50 or XYZ common stock for $25. He expects that the value of XYZ common
stock will go up to $50 a share in the near future. If it turns out to
be true, then the warrants would have been a better investment than the
common stock. If A buys the common stock, he will have a profit of $25
per share or a profit of 100% on his original investment.
Return on Investment =
= $25.00/$25.00 X 100
However, if A buys the warrants, he will gain
a higher profit margin percentage. If XYZ stock rises up to $50 a share,
then each warrant will have an intrinsic value of $40. Assuming that the
warrant's premium is still at 16.67% then the warrant's market value would
$40.00 + ($40.00 X 0.1667) = $46.69
Thus, warrants, like any leveraged investment
vehicle, are a two-edged sword, increasing both the potential return and
the potential risk to the investor. Also, when warrants are first issued,
the predetermined price at which the stock can be purchased is usually
higher than the stock's current market price. For the warrants to become
valuable, the common stock must appreciate in value. Warrants are therefore,
issued to enhance the future value of the stock to the holder. Corporations
issue warrants to make best use of their future value. For example, when
a company first goes public, the investment banking firm that handles the
underwriting often receives warrants as part of its fee for handling the
transaction. Thus, as the company grows and the value of its common stock
increases, so does the market value of its warrants.
This represents a return of 267% ( $46.68/$17.50
X 100) on A's original investment. Therefore, the warrants would
clearly be a better investment. However, if person A's prediction turned
out to be untrue and the market value of XYZ dropped sharply, then A is
better off buying the stock instead of warrants. For example, if the market
value of XYZ dropped to $5, then the ability to buy a stock at $10 per
share is not worth much
and of course, if the warrant, although long termed,
should expire before the stock price returns to a profitable level, then
the warrant becomes useful only as scrap paper. On the other hand, a stock
certificate should not expire unless the issuing company does.
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This page is created by Julia
Lee '99 and is maintained by Professor
Satyananda Gabriel of the Economics Department, Mount
Holyoke College, January 1999.