hello and welcome back to our last chapter 6 video tutorial in this tutorial we are going to build on what we did in the last tutorial when we calculated the gaps cost of equity using the Gordon dividend formula and we're going to instead of just looking at the cost of equity we're going to calculate the cost of the firm's debt in other words the interest rate that they pay on average on the borrowings that they've done and we're going to use that uh to figure out their weighted average cost of capital um in other words the discount rate that they should use for projects or the discount rate we would use if we were trying to put a value on the entire firm so the weighted average cost of capital um basically tells us the average funding cost for the firm if the firm gets part of its um Equity from shareholders and shareholders have one required rate of return and it gets part of its funding from debt holders and the debt holders have another weight of return the weighted average cost of capital averages those to say on average in order to be profitable this company needs to earn a rate of return greater than the average of the debt and Equity interest rates so we need to do a few things we calculated the cost of equity already um you can see that in an earlier tutorial but in this tutorial we need to calculate first the cost of debt in other words the interest rate that they pay we need to calculate the tax rate um how much tax have they paid and then we put those things together to calculate the weighted average cost of capital so you can see that I've got two screens over open over here I have open Yahoo finance and I also have opened my Excel so on Yahoo finance I'm going to be looking for a few specific things we can start with our summary right now Gap is trading for $32.70 per share um it opened at 3277 this morning yesterday it closed at 3288 um it's been as low as 3205 5 and as high as 3290 today we're going to use some other Pages we are going to use um key statistics key statistics is where we will find the number of shares outstanding and we're also going to use the financial statements both the income statement and the balance sheet so let's start with calculating the cost of debt in order to know their interest rate the interest rate that they pay we need a couple pieces of information we need to know how much they owe and how much they pay an interest so we can find the amount of debt that they have on the balance sheet and that's what this is this is Yahoo's balance sheet for The Gap um and they had fiscal year that ended January 27th 2012 so of course on the top I've got assets and on the bottom I've got liabilities and Equity so the two things that I need when it comes to debt is I need to know how much they have in long-term debt but I also need to know the portion of their long-term debt that they need to pay off this year as you probably remember from accounting they move the part of long-term debt that they need to pay this year into current liabilities because it needs to be paid within 12 months or one business cycle so the current portion of long-term debt is right here current or short SL current long-term debt so in 2012 they had $59,000 um those are in thousands so that's really Millions um and then in 2011 they had 3,000 so their long-term debt which I can find down here 1,66 th000 that's again in thousands and then zero so their total debt in 2012 and 2011 or their bonds really is what this means is going to be equal to the long-term portion plus the short-term portion so we can tell that sometime in 2012 they borrowed quite a bit so in order the other piece we need to calculate the rate of debt is we need to figure out their interest payments how much should they pay in interest and we can use that to calculate then their interest rate and we can get the interest expense or the interest paid on the income statement so if I go back to Yu finance and I open the income statement clicking on that down at the bottom here income statement which is where we are I can look at their revenue their cost of goods sold their gross profit all of these different things but what I'm looking for is their average interest rate so here we have our interest expense was 74,000 and that's all I need I don't need 2011's and here's why my average interest rate for this year in 2012 is going to be equal to their interest divided by the amount that they owe but we know that at the end of 2011 they started with 3,000 and they ended with 1.6 million so in the denominator we don't exactly know how much debt they had at any one time so we average them knowing that they accumulated debt along the way and I'm going to give you the formula here so that you can see that if you need to reference it all right so that is their interest rate I'm going to highlight this for us so that it'll be easy for us to come back to their interest rate or their cost of debt is 8.87% the next thing we need to do is calculate their tax rate both of these things we can also get on the income statement so their income before tax in other words their taxable income was equal to 1, 369,000 this year and last year $982,000 or a million and then their income tax expense for this year January 2012 actually that would have been last year so this data is going to come out any day now oh no for 2000 period ending January 27th 2012 we're going to get the data very soon that shows the period ending January 27th 2013 so this date is actually one year old so their income tax expense was 536,000 and for the year ended 2011 was 778 th000 so it looks like 201 might actually have been a better year so what did they pay in tax right in tax [Applause] 2012 is equal to income tax expense divided by 3.92 that does not appear to be correct let's have this go as a number I think I might have entered a number wrong so I can tell here that my tax rate coming out is 4% is not going to be correct so I'm going to double check these numbers to see if I made a mistake and I see the error that I made look income before taxes I put 13 million and it's 1 million 369,000 that's a common mistake that you'll probably make or something similar to that and how I figured out what it was or identified that it was a mistake was because I knew that nobody company was going to be paying a 4% tax rate and that raised an alarm and so I had to go back and figure out what I'd done I could have restarted the tutorial but I didn't really want to all right so if I calculate that for both years their income tax expense was 39% both in 2012 and 2011 so let's highlight that we'll use the one for 201 12 so their cost of equity we calculated in a previous tutorial and we calculated it as being equal to 15.59% and our cost of debt we just calculated at 8.87% so we know that their shareholders require 15 12 their debt holders require 8.87 let's calculate our weighted average cost of capital pardon my phone all right so we need to know the number of shares that we have outstanding in order to calculate the number of shares outstanding or figure out what that is we need to use the key statistics area on Yahoo finance key statistics we scroll down and I'm going to move over here to the right shares outstanding 579.015 so we know 4 7942 million we need to make some adjustments and here's why the reason is is that our numbers here for debt that we got in the balance sheet all numbers are in thousands so we need to adjust this to show the numbers in thousand thousands and to do that we turn the period into a comma and add a zero that way when we calculate the market value of equity um it will be comparable in units to the market value of debt and so I put a little note here for you to remember to adjust your units our current share price is going to be equal to $32.5 somebody is trying to get hold of me but I am just not going to fall for it and so our market value of equity is equal to the number of shares outstanding multiplied by the current share price so if you wanted to buy every share that the Gap had outstanding you would need to pay 15,43 353 but that's multip that's in thousands so it's really 15 billion our value of debt is equal to 1 .6 million so we can tell that they've got more Equity than debt their total Equity plus debt in other words the total amount of funds supplied by external lenders or stakeholders um investors the lenders plus the equity holders the owners plus the lenders is going to be equal to the amount supplied by debt holders plus the amount supplied by owners or shareholders so they've had a total amount of external funds supplied of about 17 billion so what percentage is that of equity and what percentage of that is debt that's what equates to our equation Equity divided by Equity plus debt that basically is just telling us the percent of funds supplied by shareholders shareholders supply 90.3% of funds debt holders supply 99.7% of funds when our tax rate is equal to 39% we've got all of the pieces we need to calculate our weighted average cost of capital so our weighted average cost of capital is going to be equal to our interest rate multiplied by the percentage of funds provided by debt holders multiplied by 1 minus the tax rate and that's because interest payments are tax deductible so that basically says after taxes if 9% of your funds come from debt holders how much will that contribute to our overall cost of capital and to that we add our percentage of equity multiplied by our cost of equity so the Gap has a weighted average cost of capital equal to 14.9% which is going to end up looking a little a little bit like 14.6% when I get us down here to only two decimals and that is how you calculate the weighted average cost of capital for a real firm