Current value and combined co WACC

eThunder Company
eThunder company is an established company in the delivery and runner services sector, matching the type of venture TAC is considering to diversify into. The service is provided by human riders as well as automatic drone delivery. As the business has expanded tremendously during the pandemic, the owners of eThunder see the opportunity to sell their business for a handsome capital gain. The owners consider a premium of 50% over the existing equity market value of eThunder to be a reasonable price to sell their company. eThunder has two main divisions, providing delivery and runner service and manufacturing and selling drone. The latest financial statements of eThunder shows the following extract:
$000
Revenue2800
Profit before interest and tax(PBIT)504
Ordinary shares (nominal value 50 cents) 5000
Reserves 3200
7% Bank loan 2000
Delivery and runner service accounts for 60% of its latest revenue and PBIT. eThunder current share price is $1.20 per share.

Combined company valuation and performance
Jimmy has no intention to venture into drone manufacturing as he believes manufacturing drones requires specialised technology and skills that TAC will not be able to master effectively. TAC has found another company willing to buy the drone business at an agreed price of $15 million, after it has acquired eThunder.
TAC estimates that the delivery and runner service business of eThunder will continue to grow after the takeover, with its revenue growing at a rate of 10% per year for the first four years after takeover, before stabilising to a growth rate of 4% per year to perpetuity thereafter. The operating profit margin is expected to be 22% per year. This is better than current performance due to cost-based synergy expected from the combination of eThunder with TAC. Tax allowable deprecation is expected to be equivalent to the capital investment needed to maintain current operations. However, TAC estimates that it would need an investment of $0.40 per $1 increase in sales of eThunder delivery and runner service business after the takeover. It is agreed that the valuation of the delivery and runner service business should be done using the free cash flow to firm method with the combined company WACC used as the discount rate.
TAC’s current share price is $0.50 per share with 100 million shares in issue. The Finance director of TAC is of the view that the company’s current fair value should be much higher than the current equity market value as the aviation industry is expected to recover soon since many countries have opened their borders,withCovid-19 entering the endemic phase. The finance director believes that the reasonable fair value of TAC should be based on 70% of its pre-pandemic level earnings of $25 million and 80% of the aviation industry average P/E ratio of 10 times before the pandemic. The announcement of the takeover has increased the share price of TAC by approximately 30%. Combined company weighted average cost of capital (WACC)It is agreed that the WACC of the combined company should be based on the betas of TAC and eThunder. The current equity beta of TAC is 2.10. TAC has $300 million of redeemable bonds in its statement of financial position, currently valued at $92 per $100 nominal. eThunder’s asset beta for its delivery and runner service business is 0.75. The asset beta of the combined company should be the weighted average of the asset betas of TAC and eThunder delivery and runner service business, weighted by the market value of equity of each company. The pre-tax cost of debt of the combined company will be 8%. TAC will maintain its existing capital structure after the takeover. Both companies pay tax at 22% per annum in the year the tax liability arises. The risk-free rate of return is 3% and the equity risk premium is 6%. Real options valuation Jimmy has attended a seminar on share options and how options can be used to value risky start-up technology businesses. Jimmy feels that delivery and runner service business can be regarded as a risky start-up business, as referred to in the seminar and wishes to gain more knowledge on this.

Required
(a) Prepare a report to the Board of Directors of TAC company, focusing on the following:(i)Calculate the current value of TAC company based on the finance director’s suggestion.(3marks)
(ii)Calculate the weighted average cost of capital for the combined company.(7marks)(iii)Calculate the value attributable to TAC from acquiring eThunder and sale of the drone manufacturing division.(12marks)
(iv)Evaluate the takeover of eThunder by TAC. In the evaluation, discuss the assumptions and/or limitations of the valuation methods used and provide justification of the valuation basis of current TAC value proposed by the finance director.(8marks)
Professional marks for the format, structure and presentation of the report(4 marks)
b) Explain how real options can be used to price start-up companies in risky ventures, like eThunder. (8marks)