P17-16. Evaluation of the implied price of an attached warrant
LG 5; Challenge
a. Straight bond value
Years Payments Discount
Rate Straight Bond Value
1–29 $ 115 13% $887.57
b. Implied price of all warrants (price with warrants − straight bond value)
c. Price per warrant Implied price of all warrants number of warrants
d. The implied price of $11.24 is below the theoretical value of $12.50, which makes the bond an
attractive investment.
P17-17. Warrant values
LG 5; Challenge
a. TVW (P0 E)N
TVW ($42 $50) 3 $24 or zero
TVW ($46 $50) 3 $12 or zero
b.
c. It tends to support the graph because the market value of the warrant for the $50 share price
appears to fall on the market value function presented in the table and graphed in part b. The table
d. The warrant premium results from a combination of investor expectations and the ability of the
investor to obtain much larger potential returns by trading in warrants rather than stock. The
e. Yes, the premium will decline to zero as the warrant expiration date approaches. This occurs due
P17-18. Personal finance: Common stock versus warrant investment
LG 5; Challenge
a. $8,000 $16 per share 500 shares
$8,000 $8 per warrant1,000 warrants
P17-19. Personal finance: Common stock versus warrant investment
LG 5; Challenge
a. $6,300 $30 per share 210 shares purchased
(2) 210 shares($28 $30) $420 (6.67%)
lost: $7 900 warrants $6,300 $7 $7 100%
d. Warrants increase the possibility for gain and loss. The leverage associated with warrants results in
higher risk as well as higher expected returns.
P17-20. Option profits and losses
LG 6; Intermediate
Option
a. 100 shares$5/share $500
$500 $200 $300
d. $300; the option would not be exercised.
e. $450; the option would not be exercised.
P17-21. Personal finance: Call option
LG 6; Intermediate
a. Stock transaction:
$70/share $62/share $8/share profit
Profit $
400
c. $600 100 shares $6/share
The stock price must rise to $66/share to break even.
d. If Carol actually purchases the stock, she will need to invest $6,200 ($62/share100 shares) and
profitability is correspondingly lower. It would take a stock price decline to $0 for a 100% loss on
the stock, but a stock price decline only to the striking price for a 100% loss on the call option.
P17-22. Personal finance: Put option
LG 5; Intermediate
a. ($45 $46)100 shares $100
The option would not be exercised above the striking price; therefore, the loss would be the price
of the option, $380.
b. The option would not be exercised above the striking price.
c. If the price of the stock rises above the striking price, the risk is limited to the price of the put
option. However, there is a 100% loss on the put.
P17-23. Ethics problem
LG 6; Challenge
As long as the portfolio manager making investments on behalf of the Harvard University endowment
fund did not purchase put options on the basis of information that was not generally available, Harvard
University should not be criticized benefiting from the purchase of put options on Enron. Using public
Case
Case studies are available on www.myfinancelab.com.
Financing L. Rashid Company’s Chemical Waste Disposal System
In this case, the student is asked to evaluate three long-term financing alternatives for the company’s proposed
waste disposal system: straight debt, debt with warrants, or a financial lease. After determining the cost of each
option on a present value basis, the student must choose the best alternative for L. Rashid Company.
a. 1. Straight debt value:
2. Implied price of all warrants $3,000,000 $2,897,437 $102,563
3. Implied price of each warrant
$ 1 0 2 , 5 6 3 $2.05
5 0 , 0 0 0
4. Theoretical value of warrant TVW (P0 E) N
b. The price is clearly too high because the lender is effectively paying $2.05 for a warrant that has an
estimated market value of $1.
c. Debt with warrants is the best option due to the high implied price, lower payments (10% interest rate,
d. Purchase alternative, financed using debt with warrants:
1. Annual interest expense
End of
Year
Loan
Payment
(1)
Beginning
Principal
(2)
Interest
Payments
[0.10(2)] (3)
Principal
[(1) (3)]
(4)
Ending
Principal
[(2) (4)] (5)
1 $1,206,345 $3,000,00
0$300,000 $906,345 $2,093,655
7
aSlight rounding error
2. After-tax cash outflows:
Year
Loan
Payment
(1)
Main-
tenance
(2)
Depre-
ciation*
(3)
Interest
(from
Part (1))
(4)
Total
Deductions
(2 3 4)
(5)
Tax
Shields
[(0.40) (5)]
(6)
After-Tax
Cash
Outflow
[(1 2) (6)]
(7)
1 $1,206,34
5$45,00
0$1,000,00
0$300,000 $1,345,000 $538,000 $713,345
*Depreciation:
1 $3,000,000 0.33 $1,000,000 (rounded)
3. Present value of cash outflows
End of Year After-Tax
Cash Outflow Discount Rate PV of
Outflows
1 $ 713,345 6% $
2,063,085
e. Lease alternative
1. Annual after-tax outflows:
Years 1–2: $1,200,000(1 0.40) $720,000
2. Present value of cash outflows
End of Year After-Tax
Cash Outflow Discount
Rate PV of
Outflows
1 $720,000 6% $ 2,109,285
f. Purchasing the waste disposal system using debt with warrant financing is the preferred alternative.
Spreadsheet Exercise
The answer to Chapter 17’s comparison of leasing versus purchasing spreadsheet problem is available on
www.pearson.com/mylab/finance.
Group Exercise
Group exercises are available on www.myfinancelab.com.
Special topics in financial management begin with this chapter’s look at hybrid and derivative securities.
Continued creativity is a defining characteristic of current financing solutions as established in the text. Students
The specifics include a leasing arrangement for the firm. Next is the description of a convertible security, either
a bond or preferred stock. The third example of creative finance is up to the discretion of the group and could