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 financial plans:

a-1. Compute the weighted average cost for four plans. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
  

a-2. Which of the four plans has the lowest weighted average cost of capital?
  

Plan D

b. What is the relationship between the various types of financing costs and the debt-to-equity ratio?

Cost
(aftertax) Weights Plan A Debt 5.0 % 20 % Preferred stock 10.0 10 Common equity 14.0 70 Plan B Debt 5.8 % 30 % Preferred stock 10.8 10 Common equity 15.0 60 Plan C Debt 6.0 % 40 % Preferred stock 11.7 10 Common equity 17.8 50 Plan D Debt 10.0 % 50 % Preferred stock 12.4 10 Common equity 19.5 40

Explanation / Answer

Answer:

Ans a-1.

Using formula, WACC = (Debt weight x debt rate) + ( Preferred weight x preferred rate) + (Equity weight x equity rate)

Plan A:
Debt (5.0% x 0.2) = 1.00 %
Preferred stock (10.0% x 0.1) = 1.00%
Common equity (14.0% x 0.7) = 9.80%

Adding debt, preferred and Equity rates together,

We have WACC of Plan A is 11.80 %

Plan B:
Debt (5.8% x 0.3) = 1.74 %
Preferred stock (10.8% x 0.10) = 1.08%
Common equity (15.0% x 0.60) = 9.00%

Adding debt, preferred and Equity rates together,

We have WACC of Plan B is 11.82 %

Plan C:
Debt (6.0% x 0.4) = 2.40 %
Preferred stock (11.7% x 0.1) = 1.17%
Common equity (17.8% x 0.5) = 8.90%

Adding debt, preferred and Equity rates together,

We have WACC of Plan C is 12.47 %

Plan D:

Debt (10.0% x 0.50) = 5.00%
Preferred stock (12.4% x 0.1) = 1.24%
Common equity (19.5% x 0.4) = 7.80%

Adding debt, preferred and Equity rates together,

We have WACC of Plan D is 14.04 %

Ans a-2:

As we can see from above calculations that Plan A has the lowest weighted average cost of capital.

Ans a-2b:

As the debt-to-equity ratio increases, the cost of every type of financing increases due to the increased risk level of the firm.

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