The interaction between the financial and investment decisions of the firm: the case of issuing warrants in a levered firm

In this paper we analyze the value of warrants and stock in a firm that has both equity and debt in its capital structure, and assume that the proceeds from exercising the warrants are reinvested in the firm. The effect of potential future scale investment on the firm's stock, debt and warrants are investigated. The warrants in our analysis are European. In this framework there are two sources for the nonstationarity of the rate of return on any kind of financial claim; the first stems from changes in the firm's capital structure, and the second is due to the potential scale increase in the value of the firm should the warrants be exercised. The effect of a potential transfer of wealth from equity-holders to debt-holders at time of exercise is analyzed. When warrants are exercised and the proceeds are reinvested in a scale expansion project, the probability of default may decrease. It follows, therefore, that ceteris paribus debt is likely to appreciate in value at the expense of equity. The method of pricing by arbitrage, as proposed by Harrison and Kreps is used to derive values for claims on the firm. Problems associated with measuring the volatility of equity are discussed.