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SUBJECT COST
ACCOUNTING
ENCANA
CORPORATION
THE COST OF CAPITAL
CASE ANALYSIS
SUMMARY
Two managers are working on an assignment, which requires them to
EnCana was created in 2002 through the merger of Pan Canadian Energy
The two managers disagree about which costs need to be taken into account
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
sense and below which it does not. Often, this is based on the firm's cost of
reflect the project's specific risk characteristics also called required rate of
return).
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
The purpose of this assignment is to find the cost of capital and to give appropriate
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
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.
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
is the largest natural gas producer in North Americas 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 also has their own community investment program that supports
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
They hold the values to conduct business ethically and responsibly while
ensuring the health and safety of employees and contractors and respecting
protect our environment. They believe the talent, ingenuity, and technical
leadership that more than 3,800 employees and contractors now are able to
recommend for the appropriate cost of capital for EnCana Corporation. Many
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.
are: common and preferred stock, and debt. In the case of EnCana
- Common stock;
- Debt.
So, we identified the capital components, next step are to calculate the cost
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
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.
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
calculated from the market price and expected future cash flows. This
Cost of Debt
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
listed debt. If necessary, rates can be adjusted for term and riskiness. If the
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
Cost of equity
The cost equity, often referred to as the required rate of return on equity, is
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
equity and debt to total capital. Market value of equity can be determined by
the end of 2005) and stock price ($56.75 on January 31, 2006).
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
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.
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
what the firm would use as a minimum for evaluating a capital project or
investment.
Cost on Debt:
ENCANAs 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 ENCANAs 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.
Interest on publicity traded = total interest payable for the year (interest on
= $406.745 Million
= 406.745/5351 = 7.60%
Average Cost on Debt = wolt * rolt + wplt * rd + wst * rst
= 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
Rate of tax can be calculated by dividing interest expense over net earnings
before tax.
T = 1260/4089
T = 30.81%
rd-at = 4.50 %
Cost on Equity
By CAPM
rs = r* + RPm (b)
RPm = rm r*
= 13.9-4.20
= 9.7
Beta = 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
Average Growth
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
rs = 16.713%
The WACC equation is the cost of each capital component multiplied by its
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
equity;
- New issue of common stock is not advisable, due to the floatation cost
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
and provide a return on those investments. Since EnCana has different types
differences in risk.
the various components cost. Thus, it will reflect the average riskiness of the
entire firms assets from raising new debt in the planning period. As a
achieve effective decision making and also to evaluate the performance of the
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