Summary

In the EnCana Corporation case, two managers - Barb Williams and Steven Lau are working
on an assignment which requires them to estimate the cost of capital for Encana Corporation
which 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 have a difference of opinion in regards to
which costs need to be taken into account to complete the assignment. The costs of different
sources of capital, the overall cost of capital and the appropriate use of the hurdle rate are not
known to the managers. As per the case, EnCana has no preferred shares outstanding.

(What is hurdle rate? – It is 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.

Company Background

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

What we sought to do?

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

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Debit Selected Data on Common Stock and Market Indexes for the year of 2005, we
examined the cost of the capital of company for the appropriate recommendation. The
objective of this assignment is to find the cost of capital and to recommend for the
appropriate cost of capital for EnCana Corporation.

Finding the cost of capital is an important step as many business decisions require capital and
hence, managers should estimate the total investment that would be required and the cost of
required capital. If the expected rate of return exceeds the cost of capital, then the company
would implement the particular project.

In our case, EnCana Corporation is planning the capital expenditure for the year 2006, and
we need to calculate the cost of the capital for which we need to follow the below mentioned
steps –

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 and
Debt.
So, we identified the capital components, next step is to calculate the cost of components,
which is the required rate of return of each capital component.

Calculating the cost of components –

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

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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).

Total value of debt (short-term and long-term debt) at the end of 2005 was $8054 million.
Note - 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.

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

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Note - This structure was calculated on most recent data and we can assume that EnCana
was operating its functions with the capital consisting 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

Note - 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 bears a cost.

Short Term loan:

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Long Term Loan:

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.

Cost on Equity:
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 We can calculate cost on equity by two methods:
 CAPM
 Dividend growth model

By CAPM:
Using SML Equation:

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 from past data:

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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:

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Recommendations

Based on our findings, we recommend 14.891% is the appropriate Cost of Capital for EnCana
Corporation. The reasons as following:
 
1) CAPM model is most appropriate method on estimating the cost of equity;
2) New capital expenditure is recommended to use the debt because the cost of debt is lower
than equity one;
3) New debt will increase the value of the firm;
4) New issue of common stock is not advisable, due to the floatation cost and information
asymmetry, or signalling; The company will try to invest in the project which is requiring
higher return.

EnCana should accept this project which will give a return of more than 14.891%, because
EnCana has to pay their investors a return of 14.891% and this will also generate profit which
can be utilized as retained earnings and increase growth of its dividend.