Question

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

Plan A Debt . 3.0 % . 25 %

Preferred stock 6.0 20

Common equity 10.0 55

Plan B

Debt 3.5 % 35 %

Preferred stock 6.5 20

Common equity 11.0 45

Plan C Debt 4.0 % 45 %

Preferred stock 16.7 20

Common equity 11.8 35

Plan D

Debt 1 1.0 % 50 %

Preferred stock 17.2 20

Common equity 13.5 30

-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.)

Plan A
Plan B
Plan C
Plan D

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

	Plan C
	Plan B
	Plan A
	Plan D

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

	All types of financing costs increase as the debt-to-equity ratio increases.
	All types of financing costs decrease as the debt-to-equity ratio increases.

Answer 1

a-1) Plan A = 3% x 0.25 + 6% x 0.20 + 10% x 0.55 = 7.45%

Plan B = 3.5% x 0.35 + 6.5% x 0.20 + 11% x 0.45 = 7.475% or 7.48%

Plan C = 4% x 0.45 + 16.7% x 0.20 + 11.8% x 0.35 = 9.27%

Plan D = 11% x 0.50 + 17.2% x 0.20 + 13.5% x 0.30 = 12.99%

a-2) Plan A has the lowest WACC.

b) All types of financing costs increase as the debt-to-equity ratio increases. As we can see in question itself, debt is increasing from plan A to D and so is all types of financing costs.