Question

Rexton Oil is an all-equity firm with 100 million shares outstanding. Rexton has $150 million in cash and expects future free cash flows of $65 million per year. Management plans to use the cash to expand the firm's operations, which will in turn increase future free cash flows to $72.8 million per year. If the cost of capital of Rexton's investments is 10%, how would a decision to use the cash for a share repurchase rather than the expansion change the share price?

Answer 1

The question concerns the impact of a share repurchase versus operation expansion on Rexton Oil's share price. A financial analysis would consider the present value of increased future cash flows from the expansion against the immediate effect of a share repurchase on the share price by reducing shares outstanding.

Step-by-step explanation:

The student is asking how a decision to use the $150 million in cash for a share repurchase instead of expanding operations would affect Rexton Oil's share price. To determine the impact on the share price, we must analyze the value created by the expansion compared to the share repurchase. The expansion increases future free cash flows from $65 million to $72.8 million, which, when discounted at the firm's cost of capital of 10%, increases the value of the firm. Conversely, a share repurchase would not change future cash flows but would decrease the number of shares outstanding, potentially increasing the value per share.

One would need to calculate the present value of the additional free cash flows due to the expansion, compare it with the current cash available for repurchase, and then determine how the repurchase would affect the share price by adjusting the number of shares outstanding. A full analysis requires the use of financial formulas and a comparison of the outcomes to decide which action would increase shareholder value more and thus lead to a higher share price.