Question

?Roybus, Inc., a manufacturer of flash? memory, just reported that its main production facility in Taiwan was destroyed in a fire. Although the plant was fully? insured, the loss of production will decrease? Roybus's free cash flow by $ 179 million at the end of this year and by $ 64 million at the end of next year. a. If Roybus has 33 million shares outstanding and a weighted average cost of capital of 13.1 %?, what change in? Roybus's stock price would you expect upon this? announcement? (Assume that the value of? Roybus's debt is not affected by the? event.) b. Would you expect to be able to sell Roybus stock on hearing this announcement and make a? profit? Explain.

Answer 1

a) Present value of decrease in free cash flows = [ $179 / (1 + 0.131)¹ ] + [ $64 / (1 + 0.131)² ] = $208.299815 million

So, the total value of equity (in case debt is not affected) will drop by $208.299815 million.

Change in share price = (-)$208.299815 million / 33 million = (-)$6.31 per share

Therefore, the stock will drop by $6.31 per share.

b) In case the markets are efficient, the above change will be incorporated immediately in the stock price and therefore, you will not be able to make any profit.