EnCana Corporation
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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 famili familiari arize ze the reader reader with with the case case organi organizat zation ion.. The follow following ing sectio section n on Case Case Analys Analysis is explores the financial condition, and some of the applications of the technique. The section ends with recommendation and conclusions of the analysis.
The The purpo purpose se of this this assi assign gnme ment nt is to find find the the cost cost of capit capital al 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, America, produces about 3 billion billion cu. ft. of natural gas per day with the cleanest cleanest burning burning of all fossil fuels. In term terms s of fina financ ncia iall and and oper operat atin ing g perf perfor orma manc nce, e, EnCa EnCana na Corp Corpora orati tion on achi achiev eved ed stro strong ng perf perfor orma manc nce e for for the the year year of 2009 2009 duri during ng a majo majorr econ econom omic ic down downtu turn rn and and a year year when 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 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, we were examined the cost of the capital of company for the appropriate recommendations. 2.0 BACKGROUND OF THE COMPANY
EnCana Corporation
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The name of EnCana is derived from Energy and Canada. The corporation was formed in 2002 with with the the merge mergerr of Pan Pan Cana Canadi dian an Energ Energy y and and Albe Albert rta a Ener Energy gy Comp Compan any. y. The The corp corpor orat ate e headquarters is located in Calgary, Alberta it is the largest natural gas producer in North America’s America’s with more than 80 percent percent of its production production being natural gas. For the year of 2009, EnCana EnCana had split split the compan company y into into two independen independentt compan companies ies that that focuse focused d on distin distinct ct businesses where the unconventional natural gas company retains the name EnCana and the integrated oil company is called Cenovus Energy. This This corpora corporatio tion n has receiv received ed numero numerous us awards awards for their their enviro environme nmenta ntall initia initiativ tives es and is recogn recognize ized d on the Dow Jones Jones Sustai Sustainab nabili ility ty Index. Index. The corpora corporatio tion n involv involved ed with with many many enviro environme nmenta ntall progra programs ms includ including ing EnCana EnCana’s ’s Enviro Environme nmenta ntall Innova Innovatio tion n Fund, Fund, suppor supports ts 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.
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2.1 Company Profile for EnCana Corp (ECA)
Address
: 855 2nd Street S.W., Suite 1800 P.O. Box 2850 Calgary, Alberta, , CN
Telephone
: (403) 645-2000
Website
: www.encana.com
Facsimile
: (403) 645-3400
Email
:
[email protected]
Business Business Descript Description ion : The Company is a producer of natural natural gas and holds natural gas and oil resource in North America. Its other operations include the transportation and marketin marketing g of crude crude oil, oil, natural natural gas and NGLs and market marketing ing of refined petroleum products. CEO
: Randall K. Eresman
Employees
: 6048
Industry
: Major Integrated Oil & Gas
2.2 Breakdown of Major Holders:
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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 company’s details including their financ financial ial inform informati ation. on. In terms terms of revenu revenue, e, EnCana EnCana is the second second among among its compet competito itors. rs. 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:
ECA 23.66B 6,048 -64.20% 18.61B 43.49% 7.74B ECA 19.95%
CNQ 36.26B 4,132 -35.00% 8.75B 57.87% 6.47B CNQ 44.77%
SU 46.20B N/A 5.70% 23.42B 39.32% 2.70B SU 1.69%
Net Income : EPS : P/E : PEG (5 yr expected): P/S:
2.30B 3.065 10.28 1.01 1.24
2.71B 5.000 13.37 2.89 4.03
1.07B 0.885 33.47 2.17 1.96
ECA
= EnCana
CNQ
= Canadian Natural Resources Limited
SU
= Suncor Energy Inc.
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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. project. In our case, EnCana Corporation Corporation planning planning the capital capital expenditure 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;
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- 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 debt in estimating estimating WACC. EnCana EnCana had issued debt in the past, past, and its bonds are public publicly ly traded. traded.
The yield yield to maturity maturity YTM is the rate that current current bondholde bondholders rs expect expect to
receive, and it is good estimate of r d, the rate of return the new bondholders are required. EnCana current required rate of return to debt holders is r d= 5.81%. Since r d is not equal to the company’s 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 holder’s rate of return. The after tax cost of debt , r d (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 ear nings before tax $4,089 mil., respectively r espectively tax rate
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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 = r d (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 r s, is the cost of common equity raised internally by reinvesting
earnings. The following methods are usually used:
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Capital Asset Pricing Model (CAMP),
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The Discounted Cash Flow method (DCF),
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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:
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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
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Estimate current expected market risk premium, RPM, which is expected expected market market return return minus minus risk-f risk-free ree rate rate using using the histor historica icall risk risk premiu premium. m. The arithm arithmeti etic c averag average e risk 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.
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The stock beta β is given to be 1.27
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Calculate r s = r RF + (RPM) β ; r s = 4.2%+(7.4%)x1.7 = 16.78%
Using Discounted Cash Flow method (DCF) ( DCF)
We calculate this using the following equation: r s = D1 /P /P0+ Expected g
Here P 0 0 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 Stock price $ Earnings 2002 23.88 1.44 2003 25.50 2.46 2004 34.20 3.75 2005 54.56 3.85 Average 34.54 2 .8 8
per Dividend 0.20 0.15 0.20 0.28 0 .2 1
per Payout 0.1389 0.0610 0.0533 0.0727 0 .0 8 1 5
ROE(e) 0.0603 0.0965 0.1096 0.0706 0 .0 8 4 3
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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%
(1+g) ; D1=0.28 x (1+7.74%) Using g we can found the year ended dividend D1=D0 (1+g) D1= $0.30
Finally we can calculate the cost of equity using DCF method: r s = D1 /P /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 firm’s own long-term debt. Bond yield of EnCana is 5.81, and we use 5% points as a bond risk premium
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r S = 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-Pl Bond-Yield-Plus-Ri us-Risk-Pre sk-Premium mium Method primarily primarily used by companies companies that are not publicly 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 stock’s 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 r d (1 - T) = 4.02% d) Cost of equity using CAMP r s = r RF + (RPM) β=16.78% e) Market value of equity = Ve = $56.75(854,900,000) = $48,515,575,000
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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 accord accordanc ance e with with the calcul calculati ation on above, above, the best best estima estimate te of the WACC WACC for Encana’s Encana’s Corporation is as follows:WACC = wd r d ( 1 - T) + w e r s = 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 WACC is the current weighted 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 management’s target capital structure.
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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 floatation cost. In contrast, contrast, if companies companies issue debt or equity to the public, then floatation 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+r d (1 – T )] t
M
.
[1+r d (1 – T )] N
EnCana Corporation’s cost of new common equity, r e, or external equity is higher than the cost of equity raised internally by reinvesting earnings, r s, because of flotation flotation costs, F, involved in issuing new common stock. 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:r e = D1 / / P0(1 – F) + g
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= 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:-
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CAMP model is most appropriate method on estimating the cost of equity;
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New capital expenditure is recommended to use the debt because the cost of debt is lower than equity one;
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New debt will increase the value of the firm;
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New issue of common stock is not advisable, due to the floatation cost and information asymmetry, or signaling;
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The company will try to invest in the project which is requiring higher return.
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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 firm’s assets from raising raising new debt in the planning planning period. As a conclusion conclusion,, our group believed believed Cost of Capital Capital is the appropriate measurement for Encana Corporations to estimate a firm’s value in order to achi achiev eve e effe effect ctiv ive e deci decisi sion on maki making ng and and also also to eval evalua uate te the the perf perform orman ance ce of the the firm firm by calculating the weights each capital component proportionately.
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REFERENCE: 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