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?

	a.	$22.059 billion, rounded to $22.06 billion
	b.	$18.088 billion, rounded to $18.09 billion
	c.	$17.647 billion, rounded to $17.65 billion
	d.	$19.588 billion, rounded to $19.59 billion.

Answer 1

Calculation of terminal value of investment at the end of year 4:

Terminal value at the end of year 4 = CF5/ke- ke-g

Cash flow (CF5) = CF4+growth

Given,

Cash flow (CF4) = 1.5 billion

Growth (g) = 2.5%

Cash flow (CF5) = 1.5 billion + 1.5 billion*2.5%

= 1.5 billion + 0.0375 billion

= 1.5375 billion

Rate of return (ke) = 11%

Terminal value at the end of year 4 = CF5/ke-g

= 1.5375 billion /11%-2.5%

= 1.5375 billion/8.5%

= 18.088 billion

Answer : 18.088 billion, rounded to 18.09 billion