Question

When Wells Fargo purchased Wachovia Bank in October 2008, global financial markets were in turmoil. Nevertheless, Wells Fargo clearly expected conditions to eventually improve, and for Wachovia to generate positive cash flows far into the future. Suppose that analysts at Wells Fargo project that their acquisition of Wachovia will generate the following stream of cash flows:

Year 1: $0.50 billion

Year 2: $1.00 billion

Year 3: $1.25 billion

Year 4: $1.50 billion

In year 5 and beyond, analysts believe that cash flows will continue to grow at a constant rate of 2.5% per year. Suppose that Wells Fargo discounted the cash flows of this investment at 11%. What is the terminal value of this investment at the end of year 4? /// Answer: $18.088 billion, rounded to $18.09 billion

Refer to the information in question #8 above.  Assuming the same constant cash flow growth rate of 2.5% per year in year 5 and beyond, and a discount rate of 11%, and including the terminal value, what is the net present value of this investment?

	a.	$15.08 billion, rounded to $15.1 billion
	b.	$3.16 billion, rounded to $3.2 billion
	c.	$14.09 billion, rounded to $14.1 billion
	d.	$13.90 billion, rounded to $13.9 billion

Answer 1

Answer is “$15.08 billion, rounded to $15.1 billion”

Cash Flow, Year 1 = $0.50 billion
Cash Flow, Year 2 = $1.00 billion
Cash Flow, Year 3 = $1.25 billion
Cash Flow, Year 4 = $1.50 billion

Growth Rate = 2.50%
Discount Rate = 11.00%

Cash Flow, Year 5 = Cash Flow, Year 4 * (1 + Growth Rate)
Cash Flow, Year 5 = $1.50 billion * 1.0250
Cash Flow, Year 5 = $1.5375 billion

Terminal Value = Cash Flow, Year 5 / (Discount Rate - Growth Rate)
Terminal Value = $1.5375 billion / (0.1100 - 0.0250)
Terminal Value = $1.5375 billion / 0.0850
Terminal Value = $18.088 billion

Net Present Value = $0.50 billion / 1.11 + $1.00 billion / 1.11^2 + $1.25 billion / 1.11^3 + $1.50 billion / 1.11^4 + $18.088 billion / 1.11^4
Net Present Value = $15.08 billion or $15.1 billion