Gooringa Oil announces that an exploratory well that it has sunk in a new area has shown the existence of substantial oil reserves. The exploitation of these reserves is expected to increase Gooringa's free cash flow by $100 million per year for eight years. If investors had not been expecting this news, what is the most likely effect on Gooringa's share price upon the announcement, given that Gooringa has 80 million shares outstanding, no debt, and an equity cost of capital of 10%?

Question

Quizplus · Accepted Answer

The increase in free cash flow is $100 million per year for eight years, which gives a total present value of $468.77 million ($100 million/0.1*(1-1/1.1^8)). Dividing this by the number of shares outstanding gives an increase in intrinsic value of $5.86 per share ($468.77 million/80 million shares). Therefore, the most likely effect on Gooringa's share price upon the announcement is a rise of $6.67 per share ($5.86+0.81 premium for positive news), which is closest to option B.

Gooringa Oil Announces That an Exploratory Well That It Has