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 Gooringa's share price can be calculated using the present value of the expected increase in free cash flow. The present value of an annuity formula, 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), can be used to calculate the total present value of the future cash flows. The total increase in value is then divided by the number of shares outstanding (80 million) to find the increase per share. The calculation shows an increase, indicating that the share price would rise, with the correct calculation aligning with option A's value.

Gooringa Oil Announces That an Exploratory Well That It Has