encana - final

EnCana Corporation 1

1.0 INTRODUCTION

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

cost of capital of the company. Our group members begin with an introduction section to

familiarize the reader with the case organization. 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 achieved 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, we were examined

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


2.0 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.

2.1 Company Profile for EnCana Corp (ECA)

Address : 855 2nd Street S.W., Suite 1800 P.O. Box 2850 Calgary, Alberta, , CN

Telephone : (403) 645-2000

Website : www.encana.com

Facsimile : (403) 645-3400

Email : [email protected]

Business Description : The Company is a producer of natural gas and holds natural gas and oil

resource in North America. Its other operations include the transportation

and marketing of crude oil, natural gas and NGLs and marketing of

refined petroleum products.

CEO : Randall K. Eresman

Employees : 6048

Industry : Major Integrated Oil & Gas

mailto:[email protected]


2.2 Breakdown of Major Holders:

The following table is the list of percentage for the major holders in EnCana Corporations:

% of Shares Held by All Insider and 5% Owners: 0%

% of Shares Held by Institutional & Mutual Fund Owners: 68%

% of Float Held by Institutional & Mutual Fund Owners: 68%

Number of Institutions Holding Shares: 475

2.3 Direct Competitor Comparison:

The direct competitors for EnCana Corporations are Canadian Natural Resources Limited and

Suncor Energy Inc. Table below showed the comparison of company’s details including their

financial information. In terms of revenue, EnCana is the second among its competitors.

However, they earned the largest net income which is 2.30B compared with its competitors.

Below is the summary of comparisons:


ECA = EnCana

CNQ = Canadian Natural Resources Limited

SU = Suncor Energy Inc.

Details ECA CNQ SU

Market Cap: 23.66B 36.26B 46.20B

Employees: 6,048 4,132 N/A

Qtrly Rev Growth: -64.20% -35.00% 5.70%

Revenue: 18.61B 8.75B 23.42B

Gross Margin: 43.49% 57.87% 39.32%

EBITDA: 7.74B 6.47B 2.70B

Details ECA CNQ SU

Oper Margins: 19.95% 44.77% 1.69%

Net Income : 2.30B 2.71B 1.07B

EPS : 3.065 5.000 0.885

P/E : 10.28 13.37 33.47

PEG (5 yr expected): 1.01 2.89 2.17

P/S: 1.24 4.03 1.96

http://finance.yahoo.com/q?s=SU

http://finance.yahoo.com/q?s=CNQ

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

http://finance.yahoo.com/q?s=SU

http://finance.yahoo.com/q?s=CNQ

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


3.0 COST OF CAPITAL

3.1 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.

3.2 Cost of debt.

The first step in calculation cost of debt to determine the rate of return that debt holders are

require. The EnCana corporation uses commercial papers, bankers’ acceptance to finance the

working capital, and it uses 30-year bonds to raise long term debt used to finance it capital

budgeting projects. Since cost of capital is mainly used in capital budgeting, we use the cost of

long term debt in estimating WACC. EnCana had issued debt in the past, and its bonds are

publicly traded. The yield to maturity YTM is the rate that current bondholders expect to

receive, and it is good estimate of rd, the rate of return the new bondholders are required.

EnCana current required rate of return to debt holders is rd= 5.81%. Since rd is not equal to the

company’s cost of debt, because interest payments are deductible, the government in effect

pays part of the total cost. So, cost of debt to the company is less that the debt holder’s rate of

return. The after tax cost of debt, rd (1 - T), is used to calculate the WACC. From given the

Income statement we calculate the tax rate. EnCana paid in year ended 31 December 2005,

$1,260 mil. Income tax, from it Net earnings before tax $4,089 mil., respectively tax rate

Tax rate = tax expenses ÷ earnings before tax ($1,260 mil. ÷ $4,089 mil.)


Tax rate = 30.81%

EnCana after tax component cost of debt is:

After tax component cost of debt = rd (1 - T)

= 5.81(1-30.81%)

= 4.02%.

3.3 Common stock.

Companies can raise common stock in two ways: issuing a new stock and by retained earnings.

The cost of common stock rs, is the cost of common equity raised internally by reinvesting

earnings. The following methods are usually used:

- Capital Asset Pricing Model (CAMP),

- The Discounted Cash Flow method (DCF),

- The Bond-Yield-Plus-Risk-Premium Method.

These methods are not mutually exclusive, no method dominates the others, and all are subject

to error.

Using CAPM to find the Cost of Equity

To estimate the cost of common stock using CAMP we proceed as follow:

- Estimate risk free rate (T-bond will be the risk free rate). In case of EnCana T-bond rate

is r RF = 4.2 %


- Estimate current expected market risk premium, RPM, which is expected market return

minus risk-free rate using the historical risk premium. The arithmetic average risk

premium which is given on Exhibit 5. was 7.4%, and geometric average risk premium

was 7.3%. We took the arithmetic average as a risk premium 7.4%. However, this

approach is not efficient one because the rapid change in the economy may cause

miscalculation of cost of equity. In the case EnCana we used this method because of the

lack other information.

- The stock beta β is given to be 1.27

- Calculate rs = r RF + (RPM) β ; rs = 4.2%+(7.4%)x1.7 = 16.78%

Using Discounted Cash Flow method (DCF)

We calculate this using the following equation:

rs = D1/P0+ Expected g

Here P0 is the current price which is $56.75, D1 expected dividend at the end of year, and g

expected growth rate in dividends. We will calculate the g using retention growth model:

g = ROE (Retention ratio)

retention ratio = (1-payout ratio) ROE.

Years Stock price $

(a)

Earnings per

share $(b)

Dividend per

share $(c)

Payout

ratio(d) c÷b

ROE(e)

b÷a2002 23.88 1.44 0.20 0.1389 0.06032003 25.50 2.46 0.15 0.0610 0.09652004 34.20 3.75 0.20 0.0533 0.10962005 54.56 3.85 0.28 0.0727 0.0706Average 34.54 2.88 0.21 0.0815 0.0843


EnCana had average return on equity ROE 8.43% over past 4 years, and dividend payout ratio

average was 8.15%, so, growth rate is below:

g = ROE (1-ppayout ratio)

= 8.43% (1 - 8.15%)

= 0.0843 x (0.9185)

= 7.74%

Using g we can found the year ended dividend D1=D0(1+g) ; D1=0.28 x (1+7.74%)

D1= $0.30

Finally we can calculate the cost of equity using DCF method:

rs = D1/P0+ Expected g

= 0.30 / 56.75 + 7.74%

= 0.53% + 7.74%

= 8.27%

Using DCF method we got the cost of equity 8.27 %

Using Bond-Yield-Plus-Risk-Premium Method

This method simply add a judgmental risk premium of 3 to 5 percentage points to the interest

rate on the firm’s own long-term debt. Bond yield of EnCana is 5.81, and we use 5% points as

a bond risk premium


rS = Bond yield + Bond risk premium

= 5.81 % + 5 %

= 10.81 %

We have calculated three methods to estimate required return on common stock for EnCana

Corporation, the CAMP estimates 16.78% , DCF method is 8.27%, and Bond-Yield-Plus-Risk-

Premium Method is 10.81%. the results are widely varied so we will choose most reasonable to

estimate WACC.

The Bond-Yield-Plus-Risk-Premium Method primarily used by companies that are not publicly

traded, so, EnCana is publicly traded company we eliminate this method.

The mostly used method is CAMP method we will choose this estimate of cost of equity to

calculate the WACC of EnCana.

3.4 Cost of Capital based on Market Value

The best estimate for the weights to be used when calculating the WACC is by referring to the

market value. The relevant data would be:-

a) The EnCana stock’s price on 31 January 2006 was $56.75.

b) Common number of shares at the end of 2005 was 854,900,000

c) After tax Cost of debt rd (1 - T) = 4.02%

d) Cost of equity using CAMP rs = r RF + (RPM) β=16.78%

e) Market value of equity = Ve = $56.75(854,900,000) = $48,515,575,000


f) As we do not have information about the bond prices we took book value of debt on

calculating WACC. Vd = $6,629,000,000

g) We = $48,515,575,000/($48,515,575,000 + $6,629,000,000) = 87.98%

h) Wd = $6,629,000,000/($48,515,575,000 + $6,629,000,000) = 12.02%

In accordance with the calculation above, the best estimate of the WACC for Encana’s

Corporation is as follows:-

WACC = wd rd ( 1 - T) + we rs

= 0.1202(4.02%) + 0.8798(16.78%)

= 0.4832% + 14.763%

= 15.25%

The weighted average cost of capital WACC for EnCana Corporation is 15.25%. Every dollar of

new capital that EnCana obtains will on average consist 12 cents of the debt with an after tax

cost of 4.02%, 88 cents of common stock with a cost of 16.78%. The average cost of each

whole dollar, WACC, is 15.25%.

Two points also should be pointed; first, the WACC is the current weighted average cost of the

company would face of new, or marginal, dollar of capital- it is not average cost of dollar raised


in the past; second, the percentage of each capital structure component, called weights, should

be based on management’s target capital structure.

3.5 Adjustments to the cost of capital on issuing new debt or equity.

In many companies equity is raised internally as retained earnings. In this case there is no

floatation cost. In contrast, if companies issue debt or equity to the public, then floatation cost

can be more important. Since EnCana Corporation case there is no information about the

flotation cost on issuing new debt. If there will be a flotation cost, F, there should be the

following adjustment on estimating the cost of debt:

N

M (1 – F ) = ∑ _ INT ( 1 – T) . + M .

t=1 [1+rd (1 – T )]t [1+rd (1 – T )]N

EnCana Corporation’s cost of new common equity, re, or external equity is higher than the

cost of equity raised internally by reinvesting earnings, rs, because of flotation costs, F,

involved in issuing new common stock. Expanding from the dividend discount model, the stock


price was $56.75 and the firm would likely have to pay the underwriter and others around 5% of

the share price to float a new issue. The cost of equity for the firm is:-

re = D1/ P0(1 – F) + g

= 0.30 / 56.75(1-0.05) + 7.74%

= 8.30%

In comparison with the previous cost of equity with DCF method rate was 8.27%, including the

floatation cost it become 8.30%.

4.0 RECOMMENDATION

Based on our findings, we recommend 15.25% 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.


5.0 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

http://www.articlesbase.com/investing-articles/understanding-the-weighted-average-cost-of-capital-854156.html

http://www.articlesbase.com/investing-articles/understanding-the-weighted-average-cost-of-capital-854156.html

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

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

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

encana - final

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