Question

Luxe Foods is contemplating acquisition of Valley Canning Company for a cash price of $180,000. Luxe currently has high financial leverage and therefore has a cost of capital of 14%. As a result of acquiring Valley Canning, which is financed entirely with equity, the firm expects its financial leverage to be reduced and its cost of capital to drop to 11%. The acquisition of Valley Canning is expected to increase Luxe's cash inflows by $20,000 per year for the first 3 years and by $30,000 per year for the next following12 years.

Required:

1. Determine whether the proposed cash acquisition is financially justified. Explain your answer.
2. If the firm's financial leverage would actually remain unchanged as a result of the proposed acquisition, would this alter your recommendation in part (a) above? Support your answer with numerical data.