Cost of Capital - Encana Corp Essay

[pic] EnCana Corporation -Cost of Capital Nabil Naouli Yong Peng Ahmed Alenazi Raj Kancharapu Table of Contents 1. Introduction2 2. History2 a. Top Competitors4 b. Major Product and Services5 c. SWOT Analysis5 3. Calculating Cost of Capital6 a. Calculating Cost of Equity7 i. Risk free rate7 ii. Market Risk Premium8 iii. Beta8 b. Calculating Cost of Debt9 c. Weighted Average Cost of Capital ( WACC )10 d. WACC- EnCana Corp. 201012 4. Discussion Questions & Summary12 a. Hurdel Rate12 b. Retained Earnings13 c. Depreciation & Deferred Taxes14 d. Summary:14 5. References15 Introduction

The case involves calculating the cost of capital for EnCana Corporation. The analysts in the case discussed about the use of several models and the components of the models to determine the cost of capital from various sources that EnCana uses. Financial statements for 2005 (Balance sheet and Income Statement as of December 31, 2005) were provided. In addition to this data, EnCana’s schedule of debt, selected data (closing stock price, EPS, Dividends per share, P/E ratio, Dividend yield and Total return) on EnCana’s common stock from 2002 to 2005 and yields on long-term government bonds from 1980 to 2005 was also provided.

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History EnCana Corporation is one of North America’s largest natural gas producers, with about 95 percent of its production being natural gas. Its strategy is to be a natural gas pure-play company focused on the development of unconventional resources. The company produced 1. 1 trillion cubic feet of natural gas in 2009. The company’s oil sands growth profile was one of the most aggressive in North America, with an additional 500 MBD (millions of barrels per day) of oil sands bitumen production expected by 2015. EnCana was formed in 2002 with the merger of Pan Canadian Energy and Alberta Energy Company.

The corporate headquarters are in Calgary, Alberta. In Canada, EnCana has operations in Alberta, northeast British Columbia as well as an off-shore operation called Deep Panuke in development off Nova Scotia. In the United States, EnCana operates in Colorado, Wyoming, Texas and Louisiana. EnCana expanded its operations in the US Rocky Mountain region with the purchase of natural gas assets and land in Northwest Colorado, in 2002. In mid 2002, it completed a major land acquisition along the Devonian Jean Marie reef margin in the Greater Sierra region in Northeast British Columbia.

In the same year, it purchased assets in the Jonah field, in Southwest Wyoming. EnCana also sold its stake in EnCana Suffield Gas Pipeline, in the same year. EnCana completed its vertical amalgamation with its wholly owned subsidiary AEC, in 2003. In the same year, it sold its 70% indirect interest in Cold Lake Pipeline System to Inter Pipeline Fund; interest in Express Pipeline System to a consortium comprised of BC Gas, Borealis Infrastructure Management, and Ontario Teachers’ Pension Plan; and its 10% interest in the Syncrude project to Canadian Oil Sands.

Further in 2003, the company acquired reserves and production facilities in Ecuador from Vintage Petroleum. In the same year, it acquired prospective natural gas development lands in the Cutbank Ridge area of the Canadian Rocky Mountain foothills. Subsequently, EnCana Oil & Gas USA, a subsidiary of EnCana, acquired natural gas and associated natural gas liquids (NGLs) production, reserves, and acreage from Mesa Hydrocarbons. It also acquired Savannah Energy, in the same year. EnCana disposed it assets in New Mexico and sold its interest in Petrovera Resources, in 2004.

In the same year, it acquired Tom Brown, located in New Mexico. The company also disposed its stake in the Kingston CoGen and Alberta Ethane Gathering System joint venture and sold its UK Central North Sea upstream assets to Nexen, in the same year. EnCana sold its Gulf of Mexico assets to Statoil, and also announced the sale of its natural gas storage business, in 2005. In the same year, EnCana and certain affiliates sold their natural gas liquids business to Provident Energy Trust. EnCana Corporation (EnCana) is one of North America’s leading natural gas producers.

It is among the largest holders of natural gas and oil resource lands onshore North America and is a technical and cost leader in the in-situ recovery of oil sands bitumen. EnCana’s other operations include the transportation and marketing of crude oil, natural gas, and natural gas liquids; as well as the refining of crude oil and the marketing of refined petroleum products. Its operations are located in Canada, the US, Ecuador, and the UK. EnCana operates under five reportable segments: Canada, the US, downstream refining, market optimization, and corporate and other.

The Canada segment is engaged in the exploration, development and production of natural gas, crude oil, and natural gas liquids (NGLs) and other related activities within the Canadian cost centre. The segment comprises the Canadian plains division, the Canadian foothills division, and the Canadian upstream operations of the integrated oil division. The Canadian foothills division includes EnCana’s key natural gas growth assets in British Columbia and Alberta. Four key resource plays are located in the Canadian Foothills division: Greater Sierra, Cutbank Ridge, and coal bed methane (CBM).

The CBM key resource play (Horseshoe Canyon CBM, and commingled shallow gas) is located within the Clearwater business unit. In addition, EnCana has established a land position in the Horn River Devonian shale, located adjacent to the Greater Sierra key resource play. The integrated oil division includes all of the assets within the integrated oil business with ConocoPhillips, as well as other bitumen interests and the Athabasca natural gas assets. The integrated oil division contains two key crude oil resource plays: Foster Creek and Christina Lake. 3 Top Competitors ? BP Plc Chevron Corporation ? ExxonMobil Corporation ? Devon Energy ? Abraxas Petroleum Corporation ? Baytex Energy Trust ? Canadian Natural Resources Ltd ? Canadian Oil Sands Trust ? Celtic Exploration Ltd. ? Compton Petroleum Corp ? Enterra Energy Trust ? Husky Energy Inc 4 Major Product and Services ? EnCana Corporation is engaged in the exploration, production, and marketing of oil and gas. The company’s key operations include the following: ? Natural gas exploration, production, and processing ? Transportation and marketing of crude oil, natural gas, and natural gas liquids ?

Refining of crude oil and the marketing of refined petroleum products 5 SWOT Analysis [pic] Calculating Cost of Capital We used Capital asset pricing model and Dividend discount models to estimate the cost of equity and used weighted average cost of long term bonds to estimate the cost of debt. Weighted average cost of capital (WACC) was used to estimate the overall cost of capital for EnCana. • What is Cost of Capital and why do we need to know ? • Opportunity cost of an investment. • Cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). The discount rate in capital budget. • Calculate Cost of Capital is a 3-step processes • Cost of capital components. • Equity capital (CAPM, DDM) • Debt capital • Capital structure: • calculate the proportion that debt and equity capital contribute to the entire enterprise • Weighting the components • Weighted Average Cost of Capital (WACC), the average cost of each dollar of cash employed in the business. 7 Calculating Cost of Equity Method 1: Capital Asset Pricing Model (CAPM) • Risk Free Rate • Market Risk Premium • The stock beta

Method 2: Dividend Discount Model (DDM) • Annual growth rate of dividend • Dividend yield (Div/P) 8 Risk free rate We used a risk-free rate equal to the US Treasury 20 year benchmark. This rate is risk free, because the US government is considered the closest measure of a risk free investment. • Treasury bill in United States approximate risk free • Time period determined- average I yr anticipated rate. • Estimated as follow: • The Average 20 yr T-bill from 1926 to 2008 is 6. 1% • The average 1-yr T-bill is 3. 8% • Term premium = 6. %-3. 8% = 2. 3% • The most recent 20 yr T-bill is 3. 5% • Anticipated average one year interest rate is 3. 5%-2. 3% = 1. 2%. • For 05 calculation using average 1-yr T-bill for 25 yrs. 5. 6% 9 Market Risk Premium The market risk premium equals the equity risk premium minus the risk free rate. The equity risk premium is the amount of return an investor expects from equity investments. It was calculated using historical information. Various online sources and our analysis would put the market risk premium around 5% • From Historical Data: 7% (Ch. 10 ) Dividend Discount Model (DDM): • Expected return is sum of dividend yield and growth rate in dividend, r = Div/P + g. • Market Risk Premium :The expected return of stock market less the risk free rate. 3. 1%+6%=9. 1%; 9. 1%-1. 2%=7. 9% 10 Beta Beta measures the expected future risk of the company compared to the overall stock market in general. We calculated the beta using historical regressions versus the stock market. • Beta • Measure the responsiveness of a stock’s return to the market return, and therefore covariance of a security with the market. Volatility, systematic risk, etc • Estimated from industry average (10 company): • Beta = 0. 96 (current) • Other sources • Yahoo : 1. 04 (current) Bloomberg: 1. 27 (05 case) • Regression analysis • Negative from 4 yearly date for 05 case (-4. 4) • calculated from recent 67 daily and weekly data 1. 36 and 1. 24 • Need to be adjusted. 11 Calculating Cost of Debt • Cost of Debt is simply the cost of borrowing. • Companies can issue debt using any debt forms ( Bonds, Loans, Preferred Stock or Common Stock ). If the firm is publicly traded, Use the market interest rate ( Yield to Maturity ) as borrowing rate. • In EnCana Corp. we take the average of Bonds YTM which is 7. 3 = (8. 125+7. 2+7. 375+6. 5)/4 • Cost of debt “ After-tax “ = ( 1 – Tax rate ) * Borrowing rate • EnCana Cost of debt “ After-tax “ = ( 1 – 0. 31 ) * 7. 3 = 5. 1% ** Note: Why we have tax-adjusted the cost of capital while we did not tax-adjust the cost of equity? Because interest payments are tax deductible but Dividends are not. [pic] Cost of Debt vs. Equity? [pic] 12 Weighted Average Cost of Capital ( WACC ) The Weighted Average Cost of Capital ( The overall opportunity cost of capital from debt , preferred equity and common equity. • The project should be undertaken only if the return on invested capital is greater than its opportunity cost. • If the project has the similar risk to the firm, you use the WACC of the firm as discount rate. • The Weighted Average Cost of Capital = Cost of Debt after tax * Proportion value represented by Debt + Cost of Equity * Proportion value represented by Equity [pic] 14 WACC- EnCana Corp. 2010 [pic] Discussion Questions & Summary 6 Hurdel Rate Why is cost of capital important? • Cost of capital: The rate that must be earned to satisfy the required rate of return of the firm’s investors • Minimum required return = cost of capital = that particular discount rate that makes NPV = 0 • If financing cost is reduced ( NPV increases ( more projects end up with NPV ; 0 ( more wealth created to shareholders. Should the hurdle rate be different for different types (Exploration and drilling Oil production from oil sands) of projects? Project’s hurdle rate (required rate of return): Reflects both project risk and cost of capital. • Incorporates risk of CFS hurdle rate = company WACC ± risk premium Example: [pic] Should the hurdle rate be based on the interest rate on the next the source of the funds? • The return generated by a security is the cost of that security to the company that issued it. cost of capital to the firm = reward to investors • The cost of capital depends primarily on the use of funds, i. e. , the risk of the CFs, not on the source • risk of CFs (systematic risk) • company capital structure 17 Retained Earnings

Capital from retained earnings is free? What type of return the shareholder expects from retained earnings? Net Income = total dividend + retained earnings • If a company cannot find profitable projects, i. e. , projects with return at least equal to k (required return on equity) , then the firm should distribute retained earnings to shareholders as dividends. • Thus, if the company is retaining shareholder’s money, then the minimum acceptable reward to an average investor is the required return on equity Required return on retained earnings = k = Required return on equity. i. e. Shareholders want the same amount as if they had gotten the retained earnings in the form of dividends, and bought more stock in the company with them. THAT is the cost of retained earnings) 18 Depreciation & Deferred Taxes Can Capital come from depreciation and is it free? What role do deferred taxed play on capital calculation? “EnCana depreciating it’s assets at a faster rate for tax purposes. Capital expenditure for next year is expected to b $7 billion” • “Accelerated depreciation” can be used for tax purposes to lower (taxable) net income in a given period.

Technically, these are tax deferrals. • Lowering taxable income now by increasing expenses should increase future taxable income (and taxes) at a later date. Deferred income taxes do not have an associated cost, as the firm does not have to pay an interest premium or compensate any party to use them. 19 Summary: The case provided us (and the class) an opportunity to learn: • the theory underlying the concept of the cost of capital; • the nature and estimation of the risk premium; how to estimate the cost of capital for various sources of funding; • the factors determining the weights to be employed in computing the cost of capital, and • how the cost of capital might be used in investment decisions References • WikiWealth. com • Yahoo. com • Cost of Capital – Alex Tajirian • Gurufocus. com • Ascertaining the divisional Beta for project evaluation -the Pure Play Method- a discussion; N. R. Parasuraman ———————– [pic] [pic] [pic]


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