Questions)

Find the cost of debt for Encana in the dialogue between Barb and Steven.

Choose all the numbers needed for the cost of equity based on the CAPM and compute the cost of equity.

cost of equity = risk-free rate + market premium * beta

Among the variables introduced in the case, you will need to choose which variables best proxy the risk-free rate and the market premium. Note there can be different opinions here. You choose what you think is the best answer and provide your own reason.

Based on Encana's book-value debt and equity on the financial statements, compute the weights of debt and equity.

Based on your answers from No. 1 - 3, compute Encana's weighted-average cost of capital.

OVERVIEW Barb Williams and Steven Lau, two managers from service firms, were attending a week-long executive education course at a well-known business school in February 2006. In preparation for the next day's classroom session, both had read an article dealing with the cost of capital. As they vigorously discussed the concept, it became clear they had several differences of opinion. Their assignment was to calculate the cost of capital for EnCana Corporation (EnCana). EnCana was a leading oil and gas producer in North America focusing on developing resource plays and the in situ recovery of oilsands bitumen. The data they gathered are presented in Exhibits 1 to 5. EnCana was created in 2002 through the merger of Pan Canadian Energy Corporation and Alberta Energy Company. The focus of the newly amalgamated company was on the discovery and development of oil and gas fields and on selling the corporation's proprietary production of natural gas, crude oil and natural gas liquids in the wholesale market to commodity purchasers with superior financial credit ratings. The company was among the largest holders of oil and natural gas resource lands in North America and prided itself in the fact that its holdings had a lower geological and/or commercial development risk and lower average decline rate than that of its competitors. Approximately 80 per cent of operating cash flow came from natural gas. The company's oilsands growth profile was one of the most aggressive in North America, with an additional 500 MBD of oilsands bitumen production expected by 2015. Steven: What we really want to know is the hurdle rate that EnCana should use for its capital investment projects. Barb: Yes, and we should decide whether the rate ought to be different for different types of projects, such as exploration and drilling, or oil production from oilsands. Steven: Looking at the balance sheet, I can see the firm raises funds from quite a few different sources. The best place to start is to look at the cost of the capital raised from each of these sources. The current liabilities, except for the "short-term obligations, are mostly trade credit, so their cost is zero. Barb: Well, the long-term debt isn't interest free. In fact, as you can see in Exhibit 3. EnCana's long- term bonds, issued at coupon rates between 6.5 per cent to 8.125 per cent, are more expensive than short-term or medium-term debt. Steven: But shouldn't we be using current yields that are much lower than the firm paid in the past? I see that one of EnCana's long-term bonds was issued on July 28, 2004, and matures on August 15, 2034. It has a 6.5 per cent coupon and is currently trading at $109.76, to yield 5.81 per cent.' Barb: Notice that EnCana also borrows short-term money from two sources, Bankers Acceptances, which are short-term notes guaranteed by a bank, and commercial paper. Steven: Well, the prime rate from banks is 5.25 per cent. Wouldn't EnCana qualify for the prime rate? The three-month commercial paper rate is extremely low, currently 3.67 per cent, which is even more attractive to the firm. In case we need more information, I also noted that the current rate on three- month government treasury bills is 3.47 per cent and long-term bonds are yielding 4.20 per cent. Barb: EnCana has no preferred shares outstanding so we can focus our analysis on its common stock Steven: Calculating the cost of common stock is reasonably straightforward. Since the common shareholders have been receiving dividends, we should use the dividend yield. Barb: No, no! All of the eamings belong to the common shareholder, not just the dividends. We should use the earnings-per-share divided by the market price. Steven: What about issuing costs? EnCana's stock price on January 31, 2006, was $56.75, and the firm would likely have to pay the underwriter and others around five per cent of the share price to float a new issue. Barb: It's not likely that EnCana will raise more than one-quarter of its new equity by issuing stock. The rest of the equity will be retained earnings, which have no cost. Steven: Retained earnings aren't free capital. They belong to the shareholders. Surely they must expect some type of return. Barb: I notice from the firm's financial statements that the return on common equity for the company was 21.4 per cent in 2005 and 24.6 per cent in 2004. I realize this is an accounting rate of return computed on the book value of the equity, but I wonder if it can be used to compute the cost of equity capital. Steven: I would guess that the funds generated by depreciation are free, and they are available in large amounts. For example, last year's earnings were over $3.4 billion. Depreciation was over $2.7 billion. Capital expenditures for next year are expected to be about $7 billion, so perhaps a significant portion of the money can come from depreciation. I also see that EnCana has a large amount of deferred taxes on its books. My understanding is that these amounts result from EnCana depreciating its assets at a faster rate for tax purposes than what the Company reports in its financial statements as well as from special tax incentives. EnCana is really deferring its tax payments and the accountant in my company told me the other day that deferred taxes amount to an interest free loan from the government. On the other hand, I can't believe that money is ever free! I am unsure how deferred taxes should be figured into our cost of capital calculation. Barb: The assigned readings mention the beta of a stock. The beta is calculated by regressing the return for EnCana against the return on the market index. I went to the library's Bloomberg system and found the beta, estimated - based on three years of weekly data ending December 2005 - to be 1.27 with an R-squared of 0.31. The beta seems to be an index of the risk of the common stock but I am not sure how we translate the beta into an estimate of the cost of common equity. Steven: What do we do once we have the costs of all sources of financing? Do we just take their average? Barb: Somehow, the average cost doesn't make sense to me. I think we should just use the cost of the next source of financing. For example, EnCana has in place a shelf prospectus for $2 billion in U.S.-denominated notes. The terms of the notes, including interest at either fixed or floating rates and expiry dates, will be determined by market conditions at the date of issue. As this shelf prospectus is unutilized (and will expire in 2006), EnCana may decide, in a month, to issue the debt in order to fund new projects. Maybe the interest rate on that issue should be used as the hurdle rate for any new projects that are undertaken with those funds. Steven: After we get this cost of capital, would you advise EnCana to use the net present value method or the internal-rate of return method to evaluate projects? Barb: I don't think it matters. The two methods both give the same answer. Steven: Well, let's get on with this calculation. We have a long night ahead of us. I wish someone would just tell us EnCana's cost of capital! Exhibit 1 ENCANA CORPORATION BALANCE SHEET AS OF DECEMBER 31, 2005 (S MILLIONS) ASSETS Current assets: $ Capital assets, net Other assets Goodwill TOTAL ASSETS $ 3,604 24,881 3,139 2,524 34,148 LIABILITIES AND EQUITY Current liabilities: Accounts payable and accrued liabilities Short-term obligations? Income tax payable Other current liabilities Current portion of long-term debt 2,741 1,425 392 1,665 73 6,296 $ Long-term debt Other long-term liabilities Deferred taxes TOTAL LIABILITIES 5,278 1,278 5,289 18,141 $ Shareholders' equity Share capital Retained earnings 5,264 10,743 16,007 $ TOTAL LIABILITIES AND EQUITY $ 34,148 Exhibit 2 ENCANA CORPORATION INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2005 ($ MILLIONS) Revenues 14,266 Expenses Production and operating expenses 6,588 Depreciation & amortization 2,769 Administrative 268 Interest, net 524 Other 28 10,177 4,089 1.260 Net earnings before income tax Income tax expense Net earnings from continuing operations Net earnings from discontinued operations Net earnings Net earnings from continuing operations per common share Net earnings per common share 2,829 597 3,426 $ 3.31 $ 4.01 Exhibit 3 ENCANA CORPORATION SCHEDULE OF DEBT Long-term debt Publicly traded, including current portion Other long-term debt Short-term debt Bankers' Acceptances Commercial Paper 5,351 1,278 6,629 369 1,056 1,425 Total long-term and short-term debt 8,054 *This amount consisted of several debt issues, all of which were fixed rate debt. Four issues are listed below: 8.125% due September 15, 2030 7.20% due November 1, 2031 7.375% due November 1, 2031 6.50% due August 15, 2034 Cana Annual Report, 2005, pages 84-86; DataStream. Exhibit 4 SELECTED DATA ON ENCANA COMMON STOCK, 2002 TO 2005 Closing Stock Earnings Dividends Price Dec. 31 Per Share Per Share (CS) (C$) (C$) P/E Dividend Ratio Yield (x) (%) Total Return (%) Year 2002 2003 2004 2005 23.88 25.50 34.20 52.56 1.44 2.46 3.75 4.01 0.20 0.15 0.20 16.6 10.4 9.12 13.1 0.84 0.59 0.58 0.53 16.45 7.41 34.90 54.50 0.28 werage 2002-2005 28.32 Exhibit 5 U.S. AND CANADIAN MARKET INDEXES AND GOVERNMENT BOND YIELDS 1980 TO 2005 S&P/TSX Average Total U.S. Govt Index Average Dividend Return 1-year Value Dividend Yield % % Bonds % Dec.31 Yield % S&P Index Value Dec.31 Total Return % Cda Govt 1-year Bonds % ear 137 126 139 166 163 14.0 15.3 9.6 10.0 10.4 9.3 8.6 9.5 11.5 11.7 11.2 7.4 200 249 232 272 351 324 381 431 462 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 7.1 4.5 5.5 4.9 4.3 4.7 4.0 3.4 3.7 3.7 3.4 3.9 3.2 2.9 2.7 2.9 2.3 2.0 1.6 1.6 1.3 1.1 1.5 1.9 1.7 1.8 1.9 34.2 (2.6) 14.9 24.3 2.5 27.1 27.6 (3.2) 21.2 32.0 (3.7) 20.9 15.9 10.0 0.1 37.5 26.6 29.9 28.3 20.8 (9.0) (11.6) (12.7) 15.2 10.8 4.9 12.0 14.8 12.3 9.6 10.9 8.4 6.5 6.8 7.7 8.5 7.9 5.9 3.9 3.4 5.3 5.9 5.5 5.6 5.1 5.1 6.1 3.5 2.0 1.2 1.9 3.6 2,269 1,954 1,985 2,552 2,400 2,901 3,066 3,160 3,390 3,970 3,257 3,512 3,350 4,321 4,214 4,714 5,927 6,699 6,486 8,414 8,934 7,688 6,615 8,221 9,247 11,272 3.7 4.5 4.0 3.2 3.7 3.1 3.0 3.1 3.4 3.3 3.8 3.2 3.1 2.3 2.4 2.3 1.8 1.6 1.7 1.3 1.3 1.6 1.9 1.7 1.7 1.7 28.8 (9.4) 5.6 31.8 (2.3) 24.0 8.7 6.1 10.6 20.4 (14.1) 11.0 (1.6) 31.2 (0.1) 14.1 27.6 14.7 (1.5) 31.0 7.4 (12.4) (12.0) 25.9 14.2 23.6 449 607 757 970 1,229 1,469 1,320 1,148 980 1,112 1,212 1,248 4.2 8.8 5.7 3.6 5.0 4.8 5.6 5.4 2.2 2.9 2.6 2.8 3.9 thmetic Average Return ometric Average Return 13.9 12.9 6.5 5.6 10.9 10.0 7.4 6.5 OVERVIEW Barb Williams and Steven Lau, two managers from service firms, were attending a week-long executive education course at a well-known business school in February 2006. In preparation for the next day's classroom session, both had read an article dealing with the cost of capital. As they vigorously discussed the concept, it became clear they had several differences of opinion. Their assignment was to calculate the cost of capital for EnCana Corporation (EnCana). EnCana was a leading oil and gas producer in North America focusing on developing resource plays and the in situ recovery of oilsands bitumen. The data they gathered are presented in Exhibits 1 to 5. EnCana was created in 2002 through the merger of Pan Canadian Energy Corporation and Alberta Energy Company. The focus of the newly amalgamated company was on the discovery and development of oil and gas fields and on selling the corporation's proprietary production of natural gas, crude oil and natural gas liquids in the wholesale market to commodity purchasers with superior financial credit ratings. The company was among the largest holders of oil and natural gas resource lands in North America and prided itself in the fact that its holdings had a lower geological and/or commercial development risk and lower average decline rate than that of its competitors. Approximately 80 per cent of operating cash flow came from natural gas. The company's oilsands growth profile was one of the most aggressive in North America, with an additional 500 MBD of oilsands bitumen production expected by 2015. Steven: What we really want to know is the hurdle rate that EnCana should use for its capital investment projects. Barb: Yes, and we should decide whether the rate ought to be different for different types of projects, such as exploration and drilling, or oil production from oilsands. Steven: Looking at the balance sheet, I can see the firm raises funds from quite a few different sources. The best place to start is to look at the cost of the capital raised from each of these sources. The current liabilities, except for the "short-term obligations, are mostly trade credit, so their cost is zero. Barb: Well, the long-term debt isn't interest free. In fact, as you can see in Exhibit 3. EnCana's long- term bonds, issued at coupon rates between 6.5 per cent to 8.125 per cent, are more expensive than short-term or medium-term debt. Steven: But shouldn't we be using current yields that are much lower than the firm paid in the past? I see that one of EnCana's long-term bonds was issued on July 28, 2004, and matures on August 15, 2034. It has a 6.5 per cent coupon and is currently trading at $109.76, to yield 5.81 per cent.' Barb: Notice that EnCana also borrows short-term money from two sources, Bankers Acceptances, which are short-term notes guaranteed by a bank, and commercial paper. Steven: Well, the prime rate from banks is 5.25 per cent. Wouldn't EnCana qualify for the prime rate? The three-month commercial paper rate is extremely low, currently 3.67 per cent, which is even more attractive to the firm. In case we need more information, I also noted that the current rate on three- month government treasury bills is 3.47 per cent and long-term bonds are yielding 4.20 per cent. Barb: EnCana has no preferred shares outstanding so we can focus our analysis on its common stock Steven: Calculating the cost of common stock is reasonably straightforward. Since the common shareholders have been receiving dividends, we should use the dividend yield. Barb: No, no! All of the eamings belong to the common shareholder, not just the dividends. We should use the earnings-per-share divided by the market price. Steven: What about issuing costs? EnCana's stock price on January 31, 2006, was $56.75, and the firm would likely have to pay the underwriter and others around five per cent of the share price to float a new issue. Barb: It's not likely that EnCana will raise more than one-quarter of its new equity by issuing stock. The rest of the equity will be retained earnings, which have no cost. Steven: Retained earnings aren't free capital. They belong to the shareholders. Surely they must expect some type of return. Barb: I notice from the firm's financial statements that the return on common equity for the company was 21.4 per cent in 2005 and 24.6 per cent in 2004. I realize this is an accounting rate of return computed on the book value of the equity, but I wonder if it can be used to compute the cost of equity capital. Steven: I would guess that the funds generated by depreciation are free, and they are available in large amounts. For example, last year's earnings were over $3.4 billion. Depreciation was over $2.7 billion. Capital expenditures for next year are expected to be about $7 billion, so perhaps a significant portion of the money can come from depreciation. I also see that EnCana has a large amount of deferred taxes on its books. My understanding is that these amounts result from EnCana depreciating its assets at a faster rate for tax purposes than what the Company reports in its financial statements as well as from special tax incentives. EnCana is really deferring its tax payments and the accountant in my company told me the other day that deferred taxes amount to an interest free loan from the government. On the other hand, I can't believe that money is ever free! I am unsure how deferred taxes should be figured into our cost of capital calculation. Barb: The assigned readings mention the beta of a stock. The beta is calculated by regressing the return for EnCana against the return on the market index. I went to the library's Bloomberg system and found the beta, estimated - based on three years of weekly data ending December 2005 - to be 1.27 with an R-squared of 0.31. The beta seems to be an index of the risk of the common stock but I am not sure how we translate the beta into an estimate of the cost of common equity. Steven: What do we do once we have the costs of all sources of financing? Do we just take their average? Barb: Somehow, the average cost doesn't make sense to me. I think we should just use the cost of the next source of financing. For example, EnCana has in place a shelf prospectus for $2 billion in U.S.-denominated notes. The terms of the notes, including interest at either fixed or floating rates and expiry dates, will be determined by market conditions at the date of issue. As this shelf prospectus is unutilized (and will expire in 2006), EnCana may decide, in a month, to issue the debt in order to fund new projects. Maybe the interest rate on that issue should be used as the hurdle rate for any new projects that are undertaken with those funds. Steven: After we get this cost of capital, would you advise EnCana to use the net present value method or the internal-rate of return method to evaluate projects? Barb: I don't think it matters. The two methods both give the same answer. Steven: Well, let's get on with this calculation. We have a long night ahead of us. I wish someone would just tell us EnCana's cost of capital! Exhibit 1 ENCANA CORPORATION BALANCE SHEET AS OF DECEMBER 31, 2005 (S MILLIONS) ASSETS Current assets: $ Capital assets, net Other assets Goodwill TOTAL ASSETS $ 3,604 24,881 3,139 2,524 34,148 LIABILITIES AND EQUITY Current liabilities: Accounts payable and accrued liabilities Short-term obligations? Income tax payable Other current liabilities Current portion of long-term debt 2,741 1,425 392 1,665 73 6,296 $ Long-term debt Other long-term liabilities Deferred taxes TOTAL LIABILITIES 5,278 1,278 5,289 18,141 $ Shareholders' equity Share capital Retained earnings 5,264 10,743 16,007 $ TOTAL LIABILITIES AND EQUITY $ 34,148 Exhibit 2 ENCANA CORPORATION INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2005 ($ MILLIONS) Revenues 14,266 Expenses Production and operating expenses 6,588 Depreciation & amortization 2,769 Administrative 268 Interest, net 524 Other 28 10,177 4,089 1.260 Net earnings before income tax Income tax expense Net earnings from continuing operations Net earnings from discontinued operations Net earnings Net earnings from continuing operations per common share Net earnings per common share 2,829 597 3,426 $ 3.31 $ 4.01 Exhibit 3 ENCANA CORPORATION SCHEDULE OF DEBT Long-term debt Publicly traded, including current portion Other long-term debt Short-term debt Bankers' Acceptances Commercial Paper 5,351 1,278 6,629 369 1,056 1,425 Total long-term and short-term debt 8,054 *This amount consisted of several debt issues, all of which were fixed rate debt. Four issues are listed below: 8.125% due September 15, 2030 7.20% due November 1, 2031 7.375% due November 1, 2031 6.50% due August 15, 2034 Cana Annual Report, 2005, pages 84-86; DataStream. Exhibit 4 SELECTED DATA ON ENCANA COMMON STOCK, 2002 TO 2005 Closing Stock Earnings Dividends Price Dec. 31 Per Share Per Share (CS) (C$) (C$) P/E Dividend Ratio Yield (x) (%) Total Return (%) Year 2002 2003 2004 2005 23.88 25.50 34.20 52.56 1.44 2.46 3.75 4.01 0.20 0.15 0.20 16.6 10.4 9.12 13.1 0.84 0.59 0.58 0.53 16.45 7.41 34.90 54.50 0.28 werage 2002-2005 28.32 Exhibit 5 U.S. AND CANADIAN MARKET INDEXES AND GOVERNMENT BOND YIELDS 1980 TO 2005 S&P/TSX Average Total U.S. Govt Index Average Dividend Return 1-year Value Dividend Yield % % Bonds % Dec.31 Yield % S&P Index Value Dec.31 Total Return % Cda Govt 1-year Bonds % ear 137 126 139 166 163 14.0 15.3 9.6 10.0 10.4 9.3 8.6 9.5 11.5 11.7 11.2 7.4 200 249 232 272 351 324 381 431 462 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 7.1 4.5 5.5 4.9 4.3 4.7 4.0 3.4 3.7 3.7 3.4 3.9 3.2 2.9 2.7 2.9 2.3 2.0 1.6 1.6 1.3 1.1 1.5 1.9 1.7 1.8 1.9 34.2 (2.6) 14.9 24.3 2.5 27.1 27.6 (3.2) 21.2 32.0 (3.7) 20.9 15.9 10.0 0.1 37.5 26.6 29.9 28.3 20.8 (9.0) (11.6) (12.7) 15.2 10.8 4.9 12.0 14.8 12.3 9.6 10.9 8.4 6.5 6.8 7.7 8.5 7.9 5.9 3.9 3.4 5.3 5.9 5.5 5.6 5.1 5.1 6.1 3.5 2.0 1.2 1.9 3.6 2,269 1,954 1,985 2,552 2,400 2,901 3,066 3,160 3,390 3,970 3,257 3,512 3,350 4,321 4,214 4,714 5,927 6,699 6,486 8,414 8,934 7,688 6,615 8,221 9,247 11,272 3.7 4.5 4.0 3.2 3.7 3.1 3.0 3.1 3.4 3.3 3.8 3.2 3.1 2.3 2.4 2.3 1.8 1.6 1.7 1.3 1.3 1.6 1.9 1.7 1.7 1.7 28.8 (9.4) 5.6 31.8 (2.3) 24.0 8.7 6.1 10.6 20.4 (14.1) 11.0 (1.6) 31.2 (0.1) 14.1 27.6 14.7 (1.5) 31.0 7.4 (12.4) (12.0) 25.9 14.2 23.6 449 607 757 970 1,229 1,469 1,320 1,148 980 1,112 1,212 1,248 4.2 8.8 5.7 3.6 5.0 4.8 5.6 5.4 2.2 2.9 2.6 2.8 3.9 thmetic Average Return ometric Average Return 13.9 12.9 6.5 5.6 10.9 10.0 7.4 6.5