[Question]

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

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er as
co
eH w
o.
rs e
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a. Which of the four plans has the lowest weighted average cost of capital? (Round to two
aC s
vi y re

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.
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ar stu

[Answer]
is

Sauer Milk Inc.

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a. Cost Weighted
(aftertax) Weights Cost
sh

Plan A
Debt 4.0% 30% 1.20%
Preferred stock 8.0 15 1.20
Common equity 12.0 55 6.60
9.00%

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 Plan B
Debt 4.5% 40% 1.80%
Preferred stock 8.5 15 1.28
Common equity 13.0 45 5.85
8.93%

Plan C
Debt 5.0% 45% 2.25
Preferred stock 18.7 15 2.81
Common equity 12.8 40 5.12
10.18%

Plan D
Debt 12.0% 50% 6.00%
Preferred stock 19.2 15 2.88
Common equity 14.5 35 5.08

m
13.96%

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

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eH w
o.
b. Plan D is higher than Plan C because all components in the capital structure
rs e
increased sharply after the firm hit the 50 percent debt level.
ou urc
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aC s
vi y re
ed d
ar stu
is
Th
sh

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