91Ó°ÊÓ

Sauer Milk Inc. wants to determine the minimum cost of capital point for the firm. Assume it is considering the following financial plans:

Plan Acost(after tax) weights

A Debt ......................................... 4.0% 30%

Preferred stock ........................ 8.0 15

Common equity ....................... 12.0 55

Plan B

A Debt ......................................... 4.5% 40%

Preferred stock ........................ 8.5 15

Common equity ....................... 13.0 55

Plan C

A Debt ......................................... 5.0% 45%

Preferred stock ........................ 18.7 15

Common equity ....................... 12.840

Plan D

A 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 the decimal point.)

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

Step by step solution

01

Meaning of Cost of Capital

Cost of capital refers to the minimum return a business needs to earn to pay the costs of the funds obtained for investment purposes.

02

Step 2:Calculation of weighted average cost of capital

Plan A

Particular	Cost after tax	Weights	Weighted Cost
Debt	4%	30%	1.2%
Preferred stock	8%	15%	1.2%
Common stock	12%	55%	6.6%
Weighted average cost of capital	9.0%

Plan B

Particular	Cost after tax	Weights	Weighted Cost
Debt	4.5%	40%	1.8%
Preferred stock	8.5%	15%	1.28%
Common stock	13%	55%	7.15%
Weighted average cost of capital	10.23%

Plan C

Particular	Cost after tax	Weights	Weighted Cost
Debt	5%	45%	2.25%
Preferred stock	18.7%	15%	2.80%
Common stock	12.8%	40%	5.12%
Weighted average cost of capital	10.17%

Plan D

Particular	Cost after tax	Weights	Weighted Cost
Debt	12%	50%	6%
Preferred stock	9.2%	15%	2.88%
Common stock	14.5%	35%	5.08%
Weighted average cost of capital	13.96%

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