Spring 2022 Class Quiz Solutions on Warranties- Finance, Florida State University

Find solution to the finance class quiz done in the Spring of 2022 at Florida State University. The test was on the topic of warrants and the answers we have provided will give you tips on how you can take your finance exams in future for success. Go through the blog to see the kind of detail you need to include in your exam solutions. Hire us our service if you need qualified experts to complete your exam on warranties.

Explain what a warrant is, the rights that warrant holders have, and the value of warrants

Exam Solution: A warrant represents a right to subscribe a certain sum of money for a company's securities at a fixed price for a stated period. Most usually, the securities in point are ordinary shares but they may also be, for example, preference shares or loan stock. Warrants can be listed on a stock exchange and traded. They impose no obligation on the holder and may be considered as a type of traded call option.

1. Rights

The rights of warrant holders are set out in the warrant certificate or other document. They are not as extensive as the rights of most other securities, concentrating on protecting the right to subscribe, the price at which the subscription is made and the worth of the securities which can be subscribed for. Warrants are exercised by sending in a subscription form to the company with a cheque for the number of shares being subscribed for at the subscription price. A warrant may confer the right to subscribe one share or the right to subscribe a fixed sum of money for shares at a price that may be adjusted for various events. The right to subscribe may be exercised up to some fixed date, which may be say five years from the date of issue of the warrants. If the holder does not exercise the warrants by that date, they expire and become worthless. The company cannot force the warrant holder to exercise his warrants, although in certain circum- stances they may be cancelled if he does not.

2. Value of warrants

Warrants tend to have vogues. In a rising market, an option to subscribe shares at a fixed price has obvious attractions. Even in a falling market, warrants will have some value. Warrants will have more speculative appeal in a volatile market and when issued by companies with a cyclical share price record. As warrants will probably never attract significant interest from conservative investors, the more speculative operators set the tone of the price movements and dealing activity. Apart from the volatility of the particular market and of the price of the share to which they relate, the value of warrants is affected by three main factors. The first is their expiry date- the longer the warrant life, the more valuable it will be. The second is the exercise price. If the exercise price is below the current share price, the warrant has a real value equal to the difference and is said to be 'in the money'. Even when the exercise price is far above the market price of the share, the warrant will still have a 'hope' value.

The third factor is the level of gearing a warrant offers an investor. For a given sum, an investor can buy a certain number of shares. Alternatively, for the same sum he can buy warrants which give him the right to subscribe for a greater number of shares. The ratio between the two numbers of shares is the gearing.

Several models exist for valuing call options and warrants which may provide some theoretical basis for attributing value when warrants are issued. However, it seems that markets and professional advisers do not yet fully understand or trust this approach. It is rare to see a company or its bankers being prepared to estimate the value of warrants in a formal document prior to the start of trading.

Prices for warrants are often assessed in the market by reference to the 'premium". The premium is the additional amount it costs an investor to purchase a share by buying a warrant and exercising it as compared to an outright purchase of the share. Whether a premium is expensive or not is judged chiefly by the three factors mentioned above. The premium is not a useful measure in all circumstances. If the exercise price is substantially higher than the current market price of the shares, the premium will inevitably be high but the actual cost to buy the warrant will be low.

Explain what warrants are issued in a company and what they are used for.

Exam Solution: Warrants have been frequently issued with loan stock to reduce the coupon payable on the stock. Instead of assessing the coupon required for the stock to stand at par, the issuer can deduct the assumed value of the warrant. The exercise price of the warrant is normally set at the current market price of the shares, or at a small premium, say no more than 10%. Typically, the total amount of subscription rights attached to the warrants will equal the nominal amount of stock to be issued, although it can be less (say half) or, rarely, more than the loan stock issue. If the market premium for warrants is in the 15-20% range, the issuers can afford to price the loan stock element to stand at say 85%, and not 100%, producing a significant saving in interest costs.

The warrants are detachable and are traded separately. As they appeal to another category of investor from the loan stock, it is not uncommon to find that stock and warrants issued together become held by largely different investors after a short period of time.

Warrants are occasionally used as 'sweeteners' in takeover offers or issued to shareholders by way of bonus issue. It seems that on such occasions the issuing company derives little immediate benefit from the exercise, owing to the difficulty the market finds in knowing how to value the warrants. The issuing company may not be greatly concerned. On the face of the accounts, there may be little sign that warrants even exist. If the warrants are exercised, the company receives cash. If they are not, they simply expire at no cost to the company. However, there must be an opportunity cost in giving a third party an option to subscribe. If the option is over a significant percentage of a company's share capital, the resulting 'overhang' may prevent the share price rising much above the exercise price of the warrants. Shareholders will also be exposed to dilution in the earnings and asset backing of their shares.