A large manufacturer is evaluating the purchase of a smaller firm. The firm has

Question

A large manufacturer is evaluating the purchase of a smaller firm. The firm has the same required return as the manufacturer, estimated at 10%; yet its actual rate of return is about 8%. Although the project appears to have a negative NPV, company executives have considered the low cost of debt financing. Because the manufacturer has no existing debt outstanding, it may borrow at only 7%. Furthermore, interest deductibility and a tax rate of 50% lower the effective cost of debt to 3.5%. Because the cost of financing the acquisition with debt is much lower than the 8% expected return, the executives are considering going ahead with the acquisition. Is their decision correct?

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