NAME Yuvraj Singh
CLASS B.B.A. (II-SEM.)
SUBJECT COST
ACCOUNTING
ASSIGNMENT – I
ENCANA
CORPORATION
THE COST OF CAPITAL
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).
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 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, 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 listeddebt 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
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
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%)
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
rs = 16.713%
Average rs = (16.713+16.519)/2 = 16.616%
Year Dividend Per Share Growth % 2002 0.20 (25.00) 2003 0.15 33.33 2004 0.20 40.00 2005 0.28 16.11
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;
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.
