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Subject: Financial Management

Assignment: Case Analysis of ENCANA CORPORATION ± Ivey

Submitted to: Mr. Asim Ilyas

Presented by: Raheem Noman (10109002)


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 µresource plays¶ and the Ú Ú 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). EnCana has no preferred shares outstanding.

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 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
1 = 0.1423 + 0.8577

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:
À âong term debts ( bonds, other long term debts, deferred taxes)
À 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:
À Short-term obligations
À Publicity traded (Bonds)
À 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
= 406.745/5351 = 7.60%
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%)
rd-at = 4.50 %
Cost on Equity:
We can calculate cost on equity by two methods:
À CAPM
À Dividend growth model

ùy CAPM:
Using SMâ 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 %
ùy 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:

Year Dividend Per Share Growth %


2002 0.2
2003 0.15 (25.00)
2004 0.2 33.33
2005 0.28 40.00
Average Growth 16.11

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%

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%

ENCANA should accept this project which will give a return of more than 14.884%, because
ENCANA has to pay their investors a return of 14.884 and this will also generate profit which
can be utilized as retained earnings and increase growth of its dividend.

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