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 most likely effect on Carbondale's stock price upon the announcement would be a rise due to the increase in expected free cash flow. To calculate the effect on the stock price, we use the present value of the additional free cash flow, discounted at the equity cost of capital. The present value of an annuity formula is used here: PV = C * [(1 - (1 + r)^-n) / r], where C is the annual cash flow ($100 million), r is the discount rate (10% or 0.1), and n is the number of years (8). The total present value is then divided by the number of shares outstanding (80 million) to find the increase per share.PV = $100 million * [(1 - (1 + 0.1)^-8) / 0.1] = $100 million * 5.3349 = $533.49 millionIncrease per share = $533.49 million / 80 million shares = $6.67Therefore, the stock price is expected to rise by $6.67 per share.

Carbondale Oil Announces That a Wildcat Well That It Has