Sauer Milk Inc, wants to determine the minimum cost of capital point for the fir

Question

Sauer Milk Inc, wants to determine the minimum cost of capital point for the firm Assume it is considering the following

a. Which of the four plans has the lowest weighted average cost of capital? (Round to two places to the right of decimal point.)

b. Briefly discuss the results from Plan C and Plan D, and why one is better than the other.

Particulars Cost of After tax) Weights Plan A Debt 4.0% 30% Perferred Stock 8.0 15 Common Equity 12.0 55 Plan B Debt 4.5% 40% Perferred Stock 8.5 15 Common Equity 13.0 45 Plan C Debt 5.0% 45% PreFerred Stock 18.7 15 Common Equity 12.8 40 Plan D Debt 12.0% 50 Preferred Stock 19.2 15 Common Equity 14.5 35

a. Which of the four plans has the lowest weighted average cost of capital? (Round to two places to the right of decimal point.)

b. Briefly discuss the results from Plan C and Plan D, and why one is better than the other.

Explanation / Answer

Weighted Average Cost of Capital (WACC) = (% of equity x cost of equity) + (% of debt x cost of debt) + (% of preferred stock x cost of preferred stock)

PLAN A

WACC = 55% x 12% + 30% x 4% + 15% x 8% = 6.6% + 1.2% + 1.2% = 9%

PLAN B

WACC = 45% x 13% + 40% x 4.5% + 15% x 8.5% = 5.85% + 1.8% + 1.28% = 8.93%

PLAN C

WACC = 40% x 12.8% + 45% x 5% + 15% x 18.7% = 5.12% + 2.25% + 2.81% = 10.18%

PLAN D

WACC = 35% x 14.5% + 50% x 12% + 15% x 19.2% = 5.98% + 6% + 2.88% = 14.86%

Plan B has lowest WACC.

(2) Plan C has lower WACC than plan D, so is preferrable for cost of servicing capital as this makes the firm's servicing of total capital the cheapest.

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