Question

Roybus, Inc., a manufacturer of flash memory, just reported that its main production facility in Taiwan was destroyed in a fire. While the plant was fully insured, the loss of production will decrease Roybus's free cash flow by $177 million at the end of this year and by $57 million at the end of next year.

a. If Roybus has 35 million shares outstanding and a weighted average cost of capital of 12.8%, what change in Roybus's stock price would you expect upon this announcement? (Assume that the value of Roybus' debt is not affected by the event.)
b. Would you expect to be able to sell Roybus's stock on hearing this announcement and make a profit? Explain.

Answer 1

a. The change in Roybus's stock price would be $5.66 per share. b. No, you would not expect to be able to sell Roybus's stock and make a profit upon hearing this announcement.

Step-by-step explanation:

a. To calculate the change in Roybus's stock price upon this announcement, we need to calculate the present value of the decrease in free cash flow. The decrease in free cash flow is $177 million at the end of this year and $57 million at the end of next year. To do this, we can use the formula for present value:

Present Value = Cash Flow / (1 + Cost of Capital)^(Time)

Using the given cost of capital of 12.8%, the present value of the decrease in free cash flow is:

Present Value = (177 / (1 + 0.128)^1) + (57 / (1 + 0.128)^2) = $198.07 million.

Since there are 35 million shares outstanding, the change in Roybus's stock price would be:

Change in Stock Price = Present Value / Number of Shares = $198.07 million / 35 million = $5.66 per share.

b. No, you would not expect to be able to sell Roybus's stock and make a profit upon hearing this announcement. The decrease in stock price is the result of the decrease in free cash flow due to the loss of production facility. This negative event is likely to have a negative impact on the market perception of the company and its stock price.