Question

Question 1. Weighted average cost of capital (LO11-1) 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........................................	4.0%	30%
Preferred stock........................................	8.0	15
Common equity........................................	12.0	55
Plan B
Debt........................................	4.5%	40%
Preferred 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

1. 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.

Answer 1

Answer :

(a.) Calculation of Weighted Average Cost of Capital :

Weighted Average Cost of Capital = (Cost of Equity * Weight of Equity ) + (Cost of Preferred Stock * Weight of Preferred Stock ) + (Cost of Debt * Weight of Debt )

Below is the table showing calculation of WACC under different Plans

PLAN A	Cost	Weights	Weighted Cost
Debt	4%	0.30	1.2%
Preferred Stock	8%	0.15	1.2%
Equity	12%	0.55	6.6%
		Total	9%

PLAN B	Cost	Weights	Weighted Cost
Debt	4.5%	0.40	1.8%
Preferred Stock	8.5%	0.15	1.275%
Equity	13%	0.45	5.85%
		Total	8.925% or 8.93%

PLAN C	Cost	Weights	Weighted Cost
Debt	5%	0.45	2.25%
Preferred Stock	18.7%	0.15	2.805%
Equity	12.8%	0.40	5.12%
		Total	10.175% or 10.18%

PLAN D	Cost	Weights	Weighted Cost
Debt	12%	0.50	6%
Preferred Stock	19.2%	0.15	2.88%
Equity	14.5%	0.35	5.075%
		Total	13.955% or 13.96%

Plan B has  has the lowest weighted average cost of capital.

(b.) Under Plan C we can see that Weighted average cost of the capital is lower than Plan D because Cost of Debt under Plan C is less than Cost of Debt under Plan D. The reason may be that due to increasing the weight of Debt the firm has now to pay more interest for borrowing more. The cost of Equity and Preferred stock makes slight difference under the two plans due to difference in weight as well as difference in Cost also.

Plan C is more better than Plan D because it has low weighted average cost of Capital and having low WACC helps to maximize the value of Firm.