Modbury Network's acquired Paradise for $6.7 billion. Paradise is properly valued by the market at $3.5 billion immediately prior to announcement of the transaction. The new company combined the search engine capabilities of one of the best-known brands (at that time) on the Internet, Paradise, with Modbury's agreements with 42 cable companies worldwide. Modbury gains access to the nearly 17 million households that are regular users of Paradise. At the time of the transaction, the combined firms, called Paradise Modbury, displayed a P/E ratio in excess of 260 based on the consensus earnings estimate of $0.31 per share. Investors had great expectations for the future performance of the combined firms, despite their lackluster profit performance since their inception. Modbury provided interactive services to home and business users over its proprietary network, telephone company circuits, and through the cable companies' infrastructure. Synergy assumptions • Modbury immediately gained 340,000 of the current Paradise user customers. 

• Annual customer service costs incurred by Modbury equal $50 per customer. 

• Annual customer revenue in the form of Modbury access charges equals $500 per customer. 

• None of the current Paradise user households are current Modbury customers. 

• New Modbury customers acquired through Paradise remain Modbury customers in perpetuity. 

• Modbury's cost of capital is 20 percent during the growth period and drops to 10 percent during the slower, sustainable growth period; 

• Modbury’s tax rate is 40 percent. 

• FCFF from synergy increases by 15 percent annually for the next 5 years and 5 percent thereafter. Its cost of capital after the high-growth period drops to 10 percent. 

• The maximum purchase price Modbury should pay for Paradise equals Paradise's current market value plus the synergy that results from the merger of the two businesses.

Required

Use the discounted cash flow (DCF) method to determine if Modbury overpaid for Paradise. [15 marks]

List two limitations of the discounted cash flow method employed in this case? [5 marks]

Answer rating: 100% (QA)

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