Escana

Summary: Two managers are working on an assignment which requires them to estimate the cost of capital for Encana Corporation; it is a leading North American oil and gas producer focusing on developing ‘resource plays’ and the in situ recovery of oil sands bitumen. EnCana was created in 2002 through the merger of Pan Canadian Energy Corporation and Alberta Energy Company. The two managers disagree about which costs need to be taken into account to complete the assignment. They are not sure about the costs of different sources of capital, the overall cost of capital and the appropriate use of the hurdle rate (The required rate of return in a discounted cash flow analysis, above which an investment makes sense and below which it does not. Often, this is based on the firm's cost of capital or weighted average cost of capital, plus or minus a risk premium to reflect the project's specific risk characteristics also called required rate of return). EnCana has no preferred shares outstanding.

Cost of Capital: The cost of capital is the rate of return that providers of capital demand to compensate them for both the time value of their money, and risk. The cost of capital is specific to each particular type of capital a company uses. At the highest level these are the cost of equity and the cost of debt, but each class of shares, each class of debt securities, and each loan will have its own cost. It is possible to combine these to produce a single number for a company’s cost of capital, the WACC. The cost of capital of a security is used to value securities, as the cost of capital is the appropriate discount rate to apply to the future cash flows that security will pay. For this reason, models that estimate the cost of capital, such as CAPM and arbitrage pricing theory, are regarded as valuation models. Conversely, the cost of capital of a security can be calculated from the market price and expected future cash flows. This approach makes sense, when, for example,...