To find the Weighted Average Cost of Capital for the energy firm EnCana.
Finding the firms market value capital structure
Value of debt:
Short Term Debt: We assume that Encana’s short-term debt is NOT a part of its permanent capital structure because Encana’s business activities are project based (mining, oil and gas) and hence assumedly require different frequencies and magnitudes of short-term debt that vary with each project.
Long-term Debt: We do not have the resources to calculate the market value of debt (as we don’t know how many of which bonds there are), therefore we will use the book value which is $6,629m.
Value of equity: Barb asks if we can use book value of equity. Considering book value of equity is rarely close to its market value(intuition – book value is just assets less liabilities, whereas market value is value of all expected future cash flows), this is not a viable option.
EnCana has 854.9 mil shares outstanding, trading at $56.75. Therefore market value of equity = 854.9 x 56.75 = 48,515.575 (Means 3:1 market to book ratio – can see clearly why you cannot use the book value of equity)
Therefore: Debt = 12%, Equity = 88% of capital structure (Apx.1).
Find cost for individual capital structure components
Historical interest rates are irrelevant in calculating cost of capital, what matters is current yield which reflects the return currently required by investors.
Cost of debt
Publicly Traded Debt: Yield is 5.81%.
We use this yield assuming that since long-term interest rates are the average of short-term rates - amidst 30 years 1-2 years difference should not particularly skew the average, therefore all four long-term bonds should be trading at a similar yield.
Other long-term debt: Yield (assuming EnCana qualifies for the prime rate) is 5.25%
Therefore weighted average cost of debt is 5.81 x 0.81 + 5.25 x 0.19 = 5.7% (Apx.2)
Cost of common equity
CAPM approach (SML equation):
We know: rf = long term bond yield = 4.20%, β =1.27 (assuming historical beta is good representation of current beta – problem – only based on 3 years of data)
We do not know the risk premium on the market
Historical risk premium: Find the average historical risk premium by subtracting average historical risk free rate from average historical return on market:
Arithmetic average: 13.9 – 6.5 = 7.4%, Geometric average: 12.9 -5.6 = 7.3%
Bond average is only 1 year bonds rather than long term rates
Increase in risk premium can actually contribute to decline in stock market returns
Forward looking risk premium
Use discount cash flow model to estimate rpM: (Apx.3).
We find the growth rate with (assuming historical growth rates are accurate representation of the future): 25yr growth rate = 5.54 %( Apx. 4)
No reason to believe future growth will be like past growth
Growth rates sensitive to period over which growth is measured (Apx.5)
We use the 25 year growth rate (due to long-term nature) to obtain a rpM of 3.3 %( Apx.6), which seems unusually low considering risk premium generally is within 3.5-6.5%.
Which risk premium to use?
If we consider that the historical risk premium tends to overstate the risk premium (we are less risk adverse due to various other forms of financial stability), and the five year growth rate of the market (i.e. the current trend) is much higher (if assumed to continue would result in a much higher risk premium, approx. 8%), it is reasonable to take the average of the two: (7.4% +3.3%)/2 = 5.35%. This value for rpM seems more reasonably within the typical range.
Using this rpM we calculate the cost of equity: re = 4.2 + 1.27(5.35) = 11%
Constant growth dividend discount model , r = + 0.1187 =12.42%
Not a lot of historical data to work off
Which model do we use? Considering the extra step of calculating the risk premium in