Carbondale Oil announces that a wildcat well that it has sunk in a new oil province has shown the existence of substantial oil reserves.The exploitation of these reserves is expected to increase Carbondale'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 Carbondale's stock price upon the announcement,given that Carbondale has 80 million shares outstanding,no debt,and an equity cost of capital of 10%?

Question

Quizplus · Accepted Answer

The increase in free cash flows is $100 million per year for 8 years, so the total present value of these cash flows is:

PV = $100 million x (1 - 1/1.1^8)/0.1 = $557.35 million

This represents the increase in the value of the company, so the increase in stock price is:

Increase in stock price = PV / number of shares outstanding = $557.35 million / 80 million shares = $6.967

Rounding to the nearest cent, the answer is (C) rise by $6.67.

Carbondale Oil Announces That a Wildcat Well That It Has