NAME Yuvraj Singh

CLASS B.B.A. (II-SEM.)

SUBJECT COST ACCOUNTING

SINHGAD COLLEGE Of ARTS & COMMERCE

HARVARD | CASE | STUDIES

ASSIGNMENT – I

ENCANA CORPORATION

THE COST OF CAPITAL

CASE ANALYSIS

SUMMARY

Two managers are working on an assignment, which requires them to

estimate the cost of capital for EnCana Corporation;

It is a leading North American oil and gas producer focusing on developing

‘resource plays’ and the in situ recovery of oil sands bitumen.

EnCana was created in 2002 through the merger of Pan Canadian Energy

Corporation and Alberta Energy Company.

The two managers disagree about which costs need to be taken into account

to complete the assignment.

They are not sure about the costs of different sources of capital, the overall

cost of capital and the appropriate use of the hurdle rate (The required rate of

return in a discounted cash flow analysis, above which an investment makes

sense and below which it does not. Often, this is based on the firm's cost of

capital or weighted average cost of capital, plus or minus a risk premium to

reflect the project's specific risk characteristics also called required rate of

return).

EnCana has no preferred shares outstanding.

INTRODUCTION

This assignment is relating to a case study of EnCana Corporation to assess the

aspects of the cost of capital of the company. The following section on Case Analysis

explores the financial condition, and some of the applications of the technique. The

section ends with recommendation and conclusions of the analysis.

The purpose of this assignment is to find the cost of capital and to give appropriate

recommendation for EnCana Corporation, which is a leading natural and gas

exploration and production Company. This company also is one of the largest natural

gas producers in North America, produces about 3 billion cu. ft. of natural gas per

day with the cleanest burning of all fossil fuels.

In terms of financial and operating performance, EnCana Corporation

/quotes/comstock/13*!eca/quotes/nls/ecaachieved strong performance for the year of

2009 during a major economic downturn and a year when benchmark natural gas

prices averaged about US$4.00 per thousand cubic feet (Mcf). EnCana Oil & Gas

explores for and produces oil in its four key natural gas resource plays (about 90% of

its total US natural gas production) located at Jonah and Piceance in the US Rockies

(Wyoming and northwest Colorado) and the Fort Worth and East Texas basins. The

corporation also owns stakes in natural gas gathering and processing assets, mainly

in Colorado, Texas, Utah, and Wyoming.

Based on the EnCana Corporation’s Balance Sheet, Income Statement, Schedule of

Debit Selected Data on Common Stock and Market Indexes for the year of 2005, I

examined the cost of the capital of company for the appropriate recommendations.

BACKGROUND OF THE COMPANY

The name of EnCana is derived from Energy and Canada. The corporation

was formed in 2002 with the merger of Pan Canadian Energy and Alberta

Energy Company. The corporate headquarters is located in Calgary, Alberta it

is the largest natural gas producer in North America’s with more than 80

percent of its production being natural gas. For the year of 2009, EnCana had

split the company into two independent companies that focused on distinct

businesses where the unconventional natural gas company retains the name

EnCana and the integrated oil company is called Cenovus Energy.

This corporation has received numerous awards for their environmental

initiatives and is recognized on the Dow Jones Sustainability Index. The

corporation involved with many environmental programs including EnCana’s

Environmental Innovation Fund, supports technologies that reduce air

emissions, increase energy efficiency, improve water conservation, enhance

waste management and develop new renewable energy.

EnCana also has their own community investment program that supports

projects in the areas where the company operates.

They invested in environmental initiatives, education, family and community

wellness, sport and recreation, as well as science, trades and technology.

This company had donated $36 million in 2008 given by its employees to

recognized charities.

This corporation also committed to provide an abundant supply of natural gas

with the cleanest burning fossil fuel to communities.

They hold the values to conduct business ethically and responsibly while

ensuring the health and safety of employees and contractors and respecting

the integrity of the environment.

In terms of their people, employees are encouraged to share ideas to

decrease costs, increase production, creates a safer place to work and

protect our environment. They believe the talent, ingenuity, and technical

leadership that more than 3,800 employees and contractors now are able to

invest for the long term.

OBJECTIVE

The objective of this assignment is to find the cost of capital and to

recommend for the appropriate cost of capital for EnCana Corporation. Many

business decisions require capital. Managers should estimate the total

investment that would be required and the cost of required capital.

The expected rate of return exceeded the cost of capital, company would

implement this project. In our case, EnCana Corporation planning the capital

expenditure for 2006 year, and we need to calculate the cost of the capital.

Firstly, to calculate the WACC (weighted average cost of capital) of EnCana

Corporation we need to find out the capital components. These components

are: common and preferred stock, and debt. In the case of EnCana

Corporation the capital components are:

- Common stock;

- Debt.

So, we identified the capital components, next step are to calculate the cost

of components, which is the required rate of return of each capital

component.

Cost of Capital

The cost of capital is the rate of return that providers of capital demand to

compensate them for both the time value of their money, and risk. The cost of

capital is specific to each particular type of capital a company uses. At the

highest level these are the cost of equity and the cost of debt, but each class

of shares, each class of debt securities, and each loan will have its own cost.

It is possible to combine these to produce a single number for a company’s

cost of capital, the WACC. The cost of capital of a security is used to value

securities, as the cost of capital is the appropriate discount rate to apply to the

future cash flows that security will pay. For this reason, models that estimate

the cost of capital, such as CAPM and arbitrage pricing theory, are regarded

as valuation models. Conversely, the cost of capital of a security can be

calculated from the market price and expected future cash flows. This

approach makes sense, when, for example, calculating a WACC.

Cost of Debt

The cost of capital of listed debt securities can be estimated in a similar

manner to equities. It is also common to compare yield spreads with other

similar securities, which roughly corresponds to the use of valuation ratios for

equities. Estimating the cost of capital for unlisted debt is more difficult. It is

also an important problem because most companies, including almost all

listed companies, have significant amounts of unlisted debt. One approach is to estimate the cost of the debt by comparing it to the yield on the most similar

listed debt. If necessary, rates can be adjusted for term and riskiness. If the

debt has been recently issued or is repayable on demand it is reasonable to

assume that it is worth close to its book value, and therefore the cost of debt

is simply the nominal interest rate. The same applies if the debt pays

a floating interest rate and there has been no significant change in its

riskiness since it was borrowed.

Cost of equity

The cost equity, often referred to as the required rate of return on equity, is

most commonly estimated using CAPM. It is also implicitly estimated when

using valuation ratios, as differences in the cost of equity is a key component

of differences in the ratings at which different companies and sectors trade. A

company may have several classes of shares, in which case each will have its

own required rate of return. Their weighted average is the cost of equity.

CAPITAL STRUCTURE OF ENCANA

Capital structure of ENCANA can be calculated by determining weight of

equity and debt to total capital. Market value of equity can be determined by

multiplying most recent number of shares (854.9 million common shares at

the end of 2005) and stock price ($56.75 on January 31, 2006).

Equity= E = No. of shares * Stock price

= 854.9 * 56.75

= $48515.575

Total value of debt (short-term and long-term debt) at the end of 2005 was

$8054 million.

Short term loan will be counted in our calculation because we assume that

ENCANA will keep taking short-term loan in future to run its routine operations

and this debt will also bear a cost.

Total Capital = Equity + Debt

= 48515.575 + 8054

= $56596.575 million

Capital Structure =Total debt / Total capital + Equity / Total capital

Capital Structure = 8054/56596.575 + 48515.575/56596.575

1 = 0.1423 + 0.8577

It means capital of ENCANA consist of 14.23% of debt, and 85.77% of equity.

This structure was calculated on most recent data and we can assume that

ENCANA was operating its functions with the capital consists of this structure.

Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital is an average representing the expected

return on all of a company's securities. Each source of capital, such as stocks,

bonds, and other debt, is assigned a required rate of return, and then these

required rates of return are weighted in proportion to the share each source of

capital contributes to the company's capital structure. The resulting rate is

what the firm would use as a minimum for evaluating a capital project or

investment.

Cost on Debt:

ENCANA’s debt can be divided into two parts:

Long term debts ( bonds, other long term debts, deferred taxes)

Short term debts (accounts payable, other accruals, income tax payable,

short term obligations)

But we will take only those debts which are coming from investors and other

financial institutions for operating ENCANA’s projects and these debts are:

Short-term obligations

Publicity traded (Bonds)

Other long term debt

Short term loans are also included while calculating WACC because we assume

that ENCANA will keep taking short term loan in future to run its routine

operations and this debt also bear a cost.

Short Term loan

Short Term loan = $1425 Million

Rate of Interest = rst = 3.52%

Amount of Interest = 1425*3.52= $50.16 Million

Long Term Loan

Other long Term Debt = $1278 Million

Rate of Interest = rolt = 5.25% (Assuming Prime Rate is charged)

Amount of Interest = 1278*5.25% = $67.095 Million

Interest on publicity traded = total interest payable for the year – (interest on

other long term debts+ interest on short term debt)

Interest on publicity traded = 524 - (50.16+67.095)

= $406.745 Million

Rate of interest on publicly traded = rd =interest/Debt

= 406.745/5351 = 7.60%

Average Cost on Debt = wolt * rolt + wplt * rd + wst * rst

= 1278/8054*5.25% + 5351/8054*7.605 +1425/8054*3.52%

= 0.833 + 5.049 + 0.622

= 6.505 %

By this rate about $524 million interest is paid by company on its debts, but

according to law interest expense is Tax exempt, and WACC is calculated for

future forecasting for projects. So in order to calculate WACC, we will take

rate of interest after tax.

Rate of tax can be calculated by dividing interest expense over net earnings

before tax.

T = 1260/4089

T = 30.81%

Average cost on debt after tax = rd-at = 6.505 (1- T)

= 6.505 (1- 30.81%)

rd-at = 4.50 %

Cost on Equity

We can calculate cost on equity by two methods:

CAPM

Dividend growth model

By CAPM

Using SML Equation:

rs = r* + RPm (b)

r* = 4.20 % (Govt. long Term Treasury Bills)

rm = 13.9% (S&P arithmetic average return)

RPm = rm – r*

= 13.9-4.20

= 9.7

Beta = 1.27

rs = 4.20 + 9.7 *1.27

rs = 16.519 %

By Dividend growth Model

Rs = (D1/ Po – F) + g

Where:

D1= next year dividend

Po = current price of share in market

F = Floatation Cost

Averse growth from past data:

rs = (Do (1+ g) /

Po – F) + g

rs = 0.28

(1+0.1611) / 56.75 (1- 0.05) + 0.1611

rs = 0.325108/53.9125 +0.1611

Ye

ar

Dividend Per

Share

Growth

%

200

20.20

(25.00)

200

30.15

33.33

200

40.20

40.00

200

50.28

16.11

Average

Growth

rs = 16.713%

Average rs = (16.713+16.519)/2 = 16.616%

WACC

The WACC equation is the cost of each capital component multiplied by its

proportional weight and then summing: 

WACC = rD (1- Tc )*( D / V )+ rE *( E / V )

Where,

Re = cost of equity

Rd = cost of debt

E = market value of the firm's equity

D = market value of the firm's debt

V = Total Capital = E + D

E/V = we = percentage of financing by equity

D/V = wd= percentage of financing by debt

T = corporate tax rate

By putting Values:

Total Equity= E = no of shares * price of shares

= 854.9 * 56.75

= $48515.575 million

Total Capital = Equity + Debt

= 48515.575+ 8054

= $56596.575 Million

WACC = wd * rd + we * re

= 8054/56596.575 * 4.5 + 48515.575/56596.575 * 16.616

= 0.6404 + 14.2436

= 14.884%

RECOMMENDATION

Based on our findings, we recommend 14.884% is the appropriate Cost of

Capital for EnCana Corporation. The reasons as following:-

- CAMP model is most appropriate method on estimating the cost of

equity;

- New capital expenditure is recommended to use the debt because the

cost of debt is lower than equity one;

- New debt will increase the value of the firm;

- New issue of common stock is not advisable, due to the floatation cost

and information asymmetry, or signaling;

The company will try to invest in the project which is requiring higher return.

CONCLUSION

The cost of capital is the key factor in choosing the mixture of debt and equity

that used to finance a firm. EnCana employ several capital components such

as common or preferred stocks, along with debt to finance their investments

and provide a return on those investments. Since EnCana has different types

of capital components, the required rates on return are different due to

differences in risk.

Therefore, the cost of capital should be calculated as a weighted average of

the various components cost. Thus, it will reflect the average riskiness of the

entire firm’s assets from raising new debt in the planning period. As a

conclusion, our group believed Cost of Capital is the appropriate

measurement for EnCana Corporations to estimate a firm’s value in order to

achieve effective decision making and also to evaluate the performance of the

firm by calculating the weights each capital component proportionately.

REFERENCE

1. http://en.wikipedia.org/wiki/EnCana_Corporation

2. http://www.encana.com/aboutus/

3. http://finance.yahoo.com/q/mh?s=ECA

4. http://www.articlesbase.com/investing-articles/

understanding-the-weighted-average-cost-of-capital-

854156.html

5. MR. PAL SIR