The weighted average cost of capital, or WACC, is a figure used to measure the economic rationality of an investment, normally expressed as a percentage, given all the means used to raise capital. It adds the costs of debt and capital to the equity capital multiplied by the market risk function. There is no reason to use a dividend price, since that is just part of the costs of capital over time. If the firm is not going to pay dividends, then this figure can be ignored.
1. Divide the total amount of needed capital by that which needs to be raised by debt. This refers to the proportion of capital raised through bonds and other loans, This then needs to be multiplied by the interest rate, expressed as a decimal such as 0.6, and the tax rate, also a decimal such as 0.2. this then covers the amount raised by debt, all relevant tax rates taken together and finally, the interest rate. This produces a single number.
2. Add that figure to the proportion of financing taken by preferred stock, so the total amount needed is divided into the amount raised in preferred stock. Normally, this figure is multiplied by the cost of the stock dividend. Since that is not being used here, it can be safely be ignored because it is not treated as a cost. If this is a new firm, an increase in the capital's value over time might not be a possibility either in the early stages. Therefore, this variable, added to the earlier one, might just be the proportion of the financing that is raised by preferred stock added to the figure from Step 1.
3. Find the market risk factor. This is a figure developed by certain banks and market research firms, expressed as a percentage, that is then brought into the equation. It refers to the riskiness of the venture as a whole. It is normally arrived at by the banks through an analysis of all other similar firms under similar conditions. This is the basic risk factor and is included into the overall cost of capital. It includes three specific figures. The first is the required return rate for the venture, the second is the historical rate of return from similar firms, and the third is the expected rate of return. This is three percentages added together. The risk is measured against the "risk-free" rate, which is normally Treasury Bonds. T-Bonds usually serve as the risk benchmark because they are virtually risk free.
4. Divide the total amount of capital needed by that which will be raised in common stock. This is your third group of figures. This refers to the proportion of financing raised through normal stock. This is then multiplied by the market risk factor. If the company under consideration is not using preferred stock, but using just normally traded stock and bonds, then the figure arrived at from Step 2 can be dropped entirely. In that case, it is just two groups of figures that are added together.
5. Add the three groups together. Add all the numbers from steps 1, 2 and 4 together to reach the WACC. The figure is weighted by the market risk factor or risk premium from Step 3. This percentage is then the weighted amount of interest a firm must pay for every dollar it raises.
- The market risk premium figure is the nature of the "weight" in the WACC. It is normally done by professionals in the industry and is part of a bank's decision as to the approval of a certain venture.