The target capital structure for QM Industries is 38% common stock, 5% preferred stock, and 57% debt. If the cost of common equity for the firm is 17.7%, the cost of preferred stock is 10.4%, the before-tax cost of debt is 7.8%, and the firm's tax rate is 35%, what is QM's weighted average cost of capital?
To calculate QM Industries' weighted average cost of capital (WACC), we need to calculate the weighted average cost for each component of the capital structure and then combine them.
1. Cost of Common Stock:
The cost of common equity is given as 17.7%.
2. Cost of Preferred Stock:
The cost of preferred stock is given as 10.4%.
3. Cost of Debt:
The before-tax cost of debt is given as 7.8%. However, we need to adjust it for the tax shield effect of interest expense. Since interest expense is tax-deductible, the after-tax cost of debt can be calculated as:
After-tax cost of debt = Before-tax cost of debt * (1 - Tax Rate)
After-tax cost of debt = 7.8% * (1 - 35%) = 5.07%
4. Weighted Average Cost of Capital:
WACC is calculated by taking the weighted average of the costs of each component of the capital structure. The weights are based on the target capital structure percentages.
WACC = (Weight of Common Stock * Cost of Common Stock) + (Weight of Preferred Stock * Cost of Preferred Stock) + (Weight of Debt * Cost of Debt)
Substituting the given values:
WACC = (0.38 * 17.7%) + (0.05 * 10.4%) + (0.57 * 5.07%)
Calculating the WACC:
WACC = (0.0666) + (0.0052) + (0.0289)
WACC = 0.1007, or 10.07%
Therefore, QM Industries' weighted average cost of capital is 10.07%.