The Encana case Study is primarily focused on calculating

the cost of capital for the firm. It begins with two managers at a weeklong

executive educational business course discussing the cost of capital. Both seem

to have their different approaches when calculating Encana’s Cost of capital.

Encana is a large oil and gas producer containing three quarters of natural

gas’s, thus leading as the largest producer in North America. The objective for

the two mangers were to figure out the cost of capital and the rate of return

which is the minimum rate a company can

earn when investing into a project.

I will be looking at analyzing Encana’s Cost of capital to help the mangers

with their final decisions on this case. In order for us to ensure we make the

appropriate decision we will need to calculate Encana’s weighted average cost

of capital. To do so, we will need to figure out the companies, Cost of Equity,

Cost of debt, and its Capital Structure. These are crucial components to help

measure the company’s stance financially. The Cost of Debt is used to help

determine the interest the company uses to pay on its borrowing. We can view

their Short term debts and Long term Debts in combination to confirm how

efficiently the company is operating when it comes to paying back its

debts. The Cost of Equity is used to

determine how proficient we are in the market and in our market returns. It

will give us an idea of how much equity our shareholders make back. Lastly we

will focus on the Capital structure on how Encana is overall operating and

growing by computing its market debts such as their bonds etc. and market

equity by observing their common shares.

Reviewing Exhibit 3, Encana’s schedule of debt, we can establish their Long-term debt totals of $6,629. There short

term debt was $1,425, giving us an overall total debt of $8,504. Given their

total debt we can compute Encana’s Capital structures of debt and the equity of

the firm. We were given that Encana had 854.9 outstanding shares, and were

advised by one of the mangers the shares were going for $56.75. Knowing this

information we can conclude that our total capital is $56596.58 Million

calculated by adding our equity and debts together. To finalise our capital

structure, if we divide our debt and equity by the total capital we will view

that Encana is made up of 14.23% Debt and 85.77% Equity. This tells us that

Encana is financially stable ensuring that they have a ton of room for more

investments.

Now in order to calculate the entire firm’s weighted average, we will need to

figure out the cost of Debt after taxes. Referring back to Encana’s balance

sheet shown on exhibit 1, I had calculated Encana’s short term and long term

debts by using the debts accounted from other investors such as publicity

traded bonds, short term obligations etc. In the case it also states that our

short-term debt, the average interest rate was %3.52. For the long-term debt,

if we relate back to the managers conversation they had indicated that the

prime rate was at %5.25 which we can use to calculate long-term debt. After computing our debts we concluded we had

$50.16 mil in short term interest and 406.75 mil in long term. These values

were needed to calculate our after tax cost of debt. By dividing interest

expense over net earnings before tax we obtained our Tax rate of %30.81 leading

us to calculate our final debt after tax at %4.50. Because we are trying to

calculate the capital cost on this case, the tax is not exempt and therefore

would need to be included to ensure we cover all grounds of debts.

We will now calculate Encana’s Cost of Equity

to ensure we have a constant return on our investments. This will give us an

idea of how the company is operating in the market, and weather we are

investing appropriately when by looking at their returns. We focused on using

the CAPM (capital asset pricing model) to help measure the variance level in

the market on the risks we are taking, whether they are good or bad decisions.

This model uses historical performance to help predict the future output results

of our investments. We have also used the dividend growth model as an

alternative method for calculating the cost of equity to show these results

through dividends paid. To figure out

CAPM, we had to analyze the expected market return and the risk free rate. We

obtained these from the arithmetic average for the markets expected rate of

returns, and the rate of return on their risk free securities such as long

–term treasury bills etc. We also required using beta level that one of the

managers found at 1.27, which was based on historical returns, measuring the

stocks volatility in relation to the index market. We concluded our analysis

and computed CAPM for Encana to have a 16.52 % growth rate on their cost of

equity. We also compared that number to the dividend growth model and found it

is relatively similar at 16.71%. This was done by viewing Encana’s Next year

dividend and dividing that by the current price less the floatation cost

(underwriting fee’s etc) take that and add the growth percentage, which provided

us with our result. This tells us that Encana is operating efficiently and

providing a constant return to our investors who continue to take risks in

investing into the company. Our shareholders will continue to take risks which

will generate us more equity and allow the company to take on more projects and

grow.

The managers were trying to figure out Encana’s Cost of capital and had many

ideas on how to calculate it, weather it was to issue debt to fund new projects

, or if they should just use the hurdle rate’s interest when funding’s those

projects. This leads us to our final question on what is Encana’s weighted

average cost of capital? With the WACC

, we will be able to evaluate the value of Encana and its financial operation

using its debts, equity, stocks etc. So

far we have calculated the firms Cost of equity at an average between the two

methods (CAPM, Dividend growth model) at 16.62%. We also figured out the cost

of debt (short term and long term debts) and concluded that after tax cost of

debt to be 4.50 %. By having all our

total equity and total capital computed as well, we can now compute the

weighted average at 14.88%. This implies that Encana’s cost of capital is

operating efficiently. Overall their financial stance is estimated at a good

range, where it is not considered too high of a risk to invest in, as they are

averaged and preforming great. They have a lot of room for future investments

as they have more equity then debt, and are in a favorable financial position

to do so. For future projects, we can measure the opportunity cost on whether

we should take it on by comparing the net present value to our WACC. This will

assist the managers to come to an agreement when deciding to fund a new project.