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Equity-Related Investments


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: 

Subscription Rights 

When a company issues additional shares of stock, its exsting shareholders run the risk of having their ownership "diluted." 

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) x 100].
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 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.
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. 

Warrants 

A warrant 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 stock itself.
  • 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 =     Profit       X       100

                                          & nbsp;     Purchase Price 
                                          = $25.00/$25.00 X  100 
                                          = 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 be:
     
      $40.00 + ($40.00 X  0.1667) = $46.69
    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.
    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. 


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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.