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EnCana Corporation

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 Corporations 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

EnCana Corporation

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 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 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 EnCanas 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.

EnCana Corporation 2.1 Company Profile for EnCana Corp (ECA) Address Telephone Website Facsimile Email

: 855 2nd Street S.W., Suite 1800 P.O. Box 2850 Calgary, Alberta, , CN : (403) 645-2000 : : (403) 645-3400 :

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 Employees Industry : Randall K. Eresman : 6048 : Major Integrated Oil & Gas

2.2 Breakdown of Major Holders:

EnCana Corporation The following table is the list of percentage for the major holders in EnCana Corporations: % of Shares Held by All Insider and 5% Owners: % of Shares Held by Institutional & Mutual Fund Owners: % of Float Held by Institutional & Mutual Fund Owners: Number of Institutions Holding Shares: 0% 68% 68% 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 companys 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: Details Market Cap: Employees: Qtrly Rev Growth: Revenue: Gross Margin: EBITDA: Details Oper Margins: Net Income : EPS : P/E : PEG (5 yr expected): P/S: ECA 23.66B 6,048 -64.20% 18.61B 43.49% 7.74B ECA 19.95% 2.30B 3.065 10.28 1.01 1.24 CNQ 36.26B 4,132 -35.00% 8.75B 57.87% 6.47B CNQ 44.77% 2.71B 5.000 13.37 2.89 4.03 SU 46.20B N/A 5.70% 23.42B 39.32% 2.70B SU 1.69% 1.07B 0.885 33.47 2.17 1.96


= EnCana = Canadian Natural Resources Limited = Suncor Energy Inc.

EnCana Corporation

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;

EnCana Corporation - 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 companys 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 holders 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

EnCana Corporation 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 %

EnCana Corporation -

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 is given to be 1.27 Calculate rs = r RF + (RPM) ; 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 2002 2003 2004 2005 Average Stock price $ Earnings 23.88 1.44 (a) share $(b) 25.50 2.46 34.20 3.75 54.56 3.85 34.54 2.88 per Dividend per Payout 0.20 0.1389 share $(c) ratio(d) cb 0.15 0.0610 0.20 0.0533 0.28 0.0727 0.21 0.0815 ROE(e) 0.0603 ba 0.0965 0.1096 0.0706 0.0843

EnCana Corporation

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 firms own long-term debt. Bond yield of EnCana is 5.81, and we use 5% points as a bond risk premium

EnCana Corporation 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-RiskPremium 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 stocks 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) =16.78% e) Market value of equity = Ve = $56.75(854,900,000) = $48,515,575,000

EnCana Corporation


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 Encanas 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 managements target capital structure.

EnCana Corporation


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) . + t=1 [1+rd (1 T )]t M .

[1+rd (1 T )]N

EnCana Corporations 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

EnCana Corporation = 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.

EnCana Corporation


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 firms 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 firms 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.

EnCana Corporation


REFERENCE: 1. 2. 3. 4.