WACC = wdrd(1-T) + wpsrps + wsrs
The cost of capital is important to calculate for any company that is making a decision on accepting or rejecting a project. If the expected rate of return on a project exceeds the calculated cost of capital, then the company should move forward with the project. The cost of capital is particularly important for Encana because they are expecting to grow in size. Calculating the WACC will be necessary for use in their capital budgeting plan.
2. After tax cost of debt:
Using the market value approach, the first step will be to determine the required rate of return debt holders require. As mentioned, the cost of capital is used in capital budgeting so I used only long term debt for calculating WACC. Also, the YTM that current bondholders expect is given, which can be a good estimate as to what the new bondholders will require:
rd = 5.81%
Tax rate = income tax expense / E.B.T. = 1,260/4,089 = 30.81%
After tax cost of debt = rd (1-T) = 5.81 (1-30.81%) = 4.02%
3. Cost of preferred stock:
It was mentioned in the text that “Encana has no preferred shares outstanding”. So calculating this portion of WACC is not necessary.
4. Cost of Equity:
Using the CAPM approach, the first thing to do is estimate the risk free rate. We can use the long term treasury bonds to do this: rRF = 4.2%
It will now be necessary to estimate the current market risk premium. I used the S&P arithmetic average return in Exhibit 5 minus the risk free rate (RPm= rm- r*) 13.9 – 4.2 = 9.7%
The stock Beta is given: 1.27
Rs= rRF + (RPm) Beta = 4.2% + (9.7%) * 1.7 = 16.52%
Calculate g using retention growth model:
G = ROE (retention ratio) & retention ratio = 1- Payout ratio
|Year |Closing Price |EPS |DPS |Payout |ROE |
|2002 |23.88 |1.44 |0.2 |0.1389 |0.0603... [continues]
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