Kinda lengthy question on a business model

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The Situation
You have $500 to spend. A friend has told you that you can use it to buy an “option contract” for 1000
shares of a company that has per share price of $30. The option costs $500. The company’s shares are
currently selling at $28.5 per share. Your friend tells you that the company is involved in a lawsuit. The result of
the lawsuit will be known in one month. If the company wins, the price per share is expected to increase by $5.
If not, the price will drop by $2.75 per share. You are not familiar with option contracts and so are also
considering other options such as using the $500 to buy shares of stock of the company. Or, you can put the
money in your savings account and earn 8%.

Question: Develop the business model for the decisions you face, assuming that the company has 25% chance of
winning the lawsuit.

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Type: Question • Score: 2 • Views: 1,252 • Replies: 7

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@mbagirl,

A savings account that pays 8%! This question must have been written in the mid-80's. Really, if you can't do the this type of thinking maybe you should consider a new major.

2 Replies

@mbagirl,

$28.50 x 1000 = $28,500.00
($28.50 + $5.00) x 1000 = $33,500.00
($28.50 - $2.75) x 1000 = $25,750.00

It will cost $500 to gain $5,000 or $500 to lose $2,750.

I'll let you do the rest to represent how the 25% chance of winning the lawsuit plays into the calculation.

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@Green Witch,

is this a Cayman Islands account...?

0 Replies

@Butrflynet,

If the company wins, the stock rises to 33.50. Your option allows you to buy it for $30 so you make 3.50 per share times 1000 shares. There is a 25% chance you make $3,500, $3000 more than you started with for a 600% gain.

If the company losses (75%), the stock price drops and your options are worthless so you lose all $500.

If you buy the stock for 28.50 you get 17.5 shares. If it goes up $5/share you make $87.50. If it goes down $5 you lose that amount. Since the likely outcome is you lose the lawsuit, there is no reason to buy the stock.

If you save it at 8% you get interest and it is a sure thing.

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@Green Witch,

The savings account part wasn't the issue... it was the Options contract portion, but thanks for the contructive help.

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@Butrflynet,

Perfect. That is exactly what I wasn't sure about. We have a group and my group was doing it completely different (and clearly wrong) so this is great validation. Thanks all!

1 Reply

@mbagirl,

You might want to look at Engineer's version. His is much more accurate.

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Kinda lengthy question on a business model

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