Question

advanced chemical industries is awaiting the verdict from a court case over whether it is liable for the clean-up of wastes on a disused factory site. if it is liable, this will result in a reduction of its free cash flow by $11 million per year for ten years. if it is not liable, there will be no effect. on the close of trading the day before the announcement of the verdict, advanced chemicals was trading at $20 per share. most investors calculate that there is a 100% chance that advanced chemicals will have a verdict returned against them. one investor, jo, has performed extensive research into the outcome of the trial and estimates that there is no chance advanced chemicals will have a verdict returned against them. given that advanced chemicals has 40 million shares outstanding and an equity cost of capital of 6% with no debt, jo's estimate of the value of a share of advanced chemicals would be how much more than the market price?

Answer 1

Jo's estimate of the value of a share of Advanced Chemicals would be $418.18 more than the market price.

Step-by-step explanation:

Jo's estimate of the value of a share of Advanced Chemicals would be $418.18 more than the market price.

To calculate this, first, we need to determine the present value of the reduction in free cash flow due to the court case. The reduction is $11 million per year for ten years, and the cost of equity is 6%. Using the formula for the present value of a perpetuity, we can calculate the present value to be $183.33 million.

Dividing this value by the number of outstanding shares (40 million), we find that each share would be worth $4.58 more than the market price ($183.33 million / 40 million = $4.58).

Finally, we multiply this value by Jo's estimate of the probability of a verdict against Advanced Chemicals (0% chance), giving us $4.58 * 100 = $458.33. Therefore, Jo's estimate of the value of a share is $458.33 more than the market price.