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Tom Baldwin can invest $6,300 in the common stock or the warrants of Lexington Life Insurance. The common stock is currently selling for $30 per share. Its warrants, which provide for the purchase of two shares of common stock at $28 per share, are currently selling for $7. The stock is expected to rise to a market price of $32 within the next year, so the expected theoretical value of a warrant over the next year is $8. The expiration date of the warrant is 1 year from the present.
a. If Mr. Baldwin purchases the stock, holds it for 1 year, and then sells it for $32, what is his total gain? (Ignore brokerage fees and taxes.)
b. If Mr. Baldwin purchases the warrants and converts them to common stock in 1 year, what is his total gain if the market price of common shares is actually $32? (Ignore brokerage fees and taxes.)
c. Repeat parts a and b, assuming that the market price of the stock in 1 year is (1) $30 and (2) $28.
d. Discuss the two alternatives and the tradeoffs associated with them.
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