Shareholder Value Analysis of Tullow Oil PLC

This report provides a comprehensive shareholder value analysis (SVA) of Tullow Oil PLC. It utilizes the SVA model to determine the company's intrinsic value, comparing it to its market capitalization. The report details the assumptions and justifications for the variables used in the model, including sales growth rate, operating margins, capital investment, working capital, tax rate, and weighted average cost of capital (WACC). A sensitivity analysis is conducted to assess the impact of changes in key variables on the company's valuation. The report also examines Tullow Oil PLC's corporate financial events, particularly its funding strategy and the advantages and disadvantages of debt financing. The analysis reveals a significant discrepancy between the SVA valuation and the market capitalization, prompting a discussion of market efficiency and information asymmetry. The conclusion summarizes the findings and offers insights into the company's current financial position and future prospects.

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SHARHOLDER VALUE ANALYSIS
OF TULLOW OIL PLC

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Table of Contents
Introduction 3
Assumptions and Explanations 4
Justification of the Variables 6
Employment of the SVA Model 7
Comparative Analysis 8
Sensitivity Analysis 9
Corporate Financial Event 10
References 14

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Introduction:
A company is an artificial entity of which the shareholders are the owners. Owner of a
business entity shall analyse the benefits and risks associated by making any investment
before actually investing into it. Prospective shareholders also make such analysis as they
would will to invest in a company which yields maximum benefit. Such analysis can be done
by various methods like Discounted Cash Flow Method, Net Assets Value Method, Net
Present Value Method, Price Multiples Method, Earnings Multiple Method etc.
Amongst other methods, Shareholder Value Analysis is also one such method which might be
adopted by the prospective shareholders to arrive at the valuation of shares or the business
entity. The premise on which the Shareholder Value Analysis (SVA) Method is built is to
maximize the net worth/wealth of the shareholders. The value of a company is computed
based on the returns it can generate for its shareholders.
An investor may be of two categories. The first category of investor is one who invests into a
company purely to attain short term income like dividends, short term gains. Such investors
have an objective to materialise the benefits shortly without any plans of holding it for long
term. The second category of investors are the one who does not invest just for the sake of
investing. Such investors want to park their excess money lying with them so that it can yield
maximum benefit in long term. Before investing, they look into each and every aspect of the
proposed investment, the risks associated with it and the returns that it can generate in long
run. The investor may be from finance or non-finance background. When the investor is from
non-finance background, he generally opts for a valuation report to be assured that the
investment is just not made. Then arises the need of valuation analysis.
For valuation, the method to be adopted should be chosen wisely. The purpose of valuation is
not just that how much returns can the investment generate but it also serves the purpose of
investors as to whether the investment can meet the expectations of the investor.
SVA is a modern approach of valuing the business of an entity. As the name suggests, SVA
method measures the company’s ability to maximize the shareholder’s return on investment
by creating wealth. The owners of a business would always want to maximise their return on
investment. SVA is an appropriate method as its objective meets with that of the investor.
Few advantages of SVA Method are:
 The strategic decisions are taken that are generally spread over long period.

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 It has a universal approach, that is the methodology remains the same for different
companies in different regions across the globe which shall also attract investors from
foreign.
 Its findings help the company to focus on its objective of maximising wealth by
increasing the future cash flows
Assumptions and Explanations while valuing the company under SVA Method:
 The audited financial reports available on the website of the company has been taken
for making various calculations to arrive at the value of the company.
 Sales Growth is taken as average of sales growth for the last 5 years.
 Operating Profit is the Net Operating Profit achieved from operations of the company.
 Associate Company’s share of profit is taken the percentage of minority shareholders
in the equity capital of the company.
 Tax Rate is taken at 20% which is the standard rate prescribed under tax laws for
companies in United Kingdom.
 Increase in Capital Investment is taken as percentage of difference in the present
year’s fixed assets over the previous year’s fixed assets. In present case, fixed assets
taken are goodwill, intangible exploration and evaluation assets, property plant and
equipment.
 Increase in Working Capital is taken as percentage of difference in present year’s net
working capital over the previous year’s net working capital. In present case,
Inventories, Trade receivables, other current assets, current tax assets, trade and other
payables, provisions and current tax liabilities are taken as components of net working
capital. Cash and cash equivalents has been excluded from the calculations.
 The calculations has been computed keeping the forecast period for 5 years.
 The required rate of return is the same as the Weighted Average Cost of Capital
(WACC). WACC is calculate using the weights of equity and debt in respective
proportion and multiplied with equity and debt cost of capital respectively. The cost of
debt is arrived at by dividing the total finance cost with the total debt value for the year
ended 2015 which includes long term and short term debt.
 Cost of Equity is calculate using the Capital Asset Pricing Model (CAPM) Method.
The Beta factor, which is the sensitivity factor is taken at 1.28 which is the existing beta
factor for the company. The Market Returns is at 7.2%.

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 Marketable Securities like short term derivative financial instruments and cash and
cash equivalents has been taken.
Tullow Oil Plc
Information Table
Last sales 1,607 million
Sales growth 16.46% per year
Op. Profit Margin -68.1% of sales
Associate Cos profit 2.22- million
Tax rate 20% of op. profit margin
Inc. Cap. Inv. 0.48% of change in sales
Inc. W. Cap. -96.90% of change in sales
Planning Horizon 5 years
Required Rate of Return 5.12%
Mkt Securities and cash 762 million
SVA Calculation
Year 1 2 3 4 5 6+
Sales 1,871 2,179 2,538 2,955 3,441 3,441
Profit (1,274) (1,483) (1,727) (2,012) (2,343) (2,343)
Associate Profit 0.71- 0.23- 0.07- 0.02- 0.01- 0.01-
LessTax - - - - - -
Less ICI 1.26 1.47 1.72 2.00 2.33 2.33
Less IWC (256) (298) (347) (405) (471) -471
Operating Cash Flow (1,019) (1,187) (1,382) (1,609) (1,874) (1,874)
PV of cash flows (970) (1,074) (1,190) (1,318) (1,460) (28,540)
NPV (34,551)
Add mkt secs 762
Less debt 4,336
Equity Value SVA (38,125) million
Actual Value 2,767 -1378.1%
Based on the assumptions, inputs and the calculations made, the valuation of the company
is arrived at (38,125) million as against its market value of 2,767 million. The investment
into this company is not at all an option to be given any consideration as it is (1378.1%)
of the market valuation. Prima facie, the investment does not look feasible. As understood
from the past performance of the company, the sales has been decreasing drastically. Also
there is no profits derived from the operations which means that the company has not
even attained its break even. As seen from the above table, the Market value of debt is
higher than that of equity. The company’s business is yet to accelerate.
Justification of the variables used in the SVA Model:

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In calculating Tullow Oil Plc’s value through SVA Model, a number of key variables were
employed. Each variable’s justification has been provided in the subsequent paragraphs:
Sales Growth Rate:
A conservative growth rate of 5.3% was considered to calculated the revenues over next 6
years. The challenges mainly faced by the industry in which company operates is to respond
equally robust to the uncertainties which is mainly price. According to the one of Chief
Executives of Tullow Oil Plc, the company have a portfolio of low cost oil assets which are
considered as world class and would be able to produce around one lakh bopd in the year
2017. The company believes that such newest technology in the world might grab company a
major position in East Africa. (Tullow Oil Pls Annual Report, 2015, p. 1).
Operating Margins:
The reasoning for the assumption that operating profit margins will remain constant at -
68.1% of the sales. is from the firm’s statement made that it will be challenging to respond to
the uncertainties associated. Plans are already in motion to produce one lakh barrel of petrol
and diesel in the year 2017, which will deliver greater reduction in operating costs and in turn
preserve a steady growth in operating margins for the coming financial years.
Incremental Capital Investment:
A small incremental capital investment of 0.48% is consistent with the company’s statement
that its capex will potentially will reduce from $0.9 billion to $0.3 billion., a move that
warrants fewer capital investments in the way of fixed assets.
Working Capital Investment:
A relatively higher working capital investment of 96.90% is unusual, particularly in the oil
exploration operating industry. The constant salary costs, shorter credit period for the
purchases of the company, etc are often dictated by yearly trends. Simply put, routine
injection of working capital to manage supply and demands would always be a prerequisite.
Tax Rate:

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A tax rate of 20% appears reasonable since UK corporation tax rate tend to remain fairly
static..
Weighted Average Cost of Capital:
The WACC value of 5.12% was calculated through a number of key inputs. The Capital
Asset Pricing Model (CAPM) was employed to derive the cost of equity of 8.83%. Tullow
Oil Plc’s beta (1.28), a key component in the CAPM, was obtained from the Thomson
Reuters website as on 23rd January 2017. Unlike other institutions, Thomson Reuters
computes a company’s beta using historical adjusted betas’ measured against monthly
observations of industry average. According to Graham and Dodsville, (2005) a longer
timeframe is particularly useful for stable companies like Tullow Oil Plc, based on the
hypothesis that past performance will be a reliable indicator of future outcomes. Significant
shift in a firm’s risk profile is unlikely to be recognised promptly by way of a historically
derived beta. Similar caution is also granted for the 3.44% risk-free rate. Critically speaking,
using the official 3-month government bond rate as a proxy for the risk-free rate is easier said
than done. It is only recently that Fitch, a leading credit-rating agency, issued a warning to
downgrade the UK’s triple ‘A’ ratings should debt levels remain high. Stripping the country
of its long-standing ratings would immediately raise the risk-factor of bonds and compel the
government to hike its interest rates. With Greece and Spain on the verge of outright default
and countries like the US - otherwise known to have a fairly stable economy, in fears of
further downgrade, a true risk-free rate appears more to be the figment of one’s imagination
as opposed to reality. Similarly, the cost of debt at 3.44% may also be of questionable origin.
Due to the difficultly in tracing market prices of each individual bond, an overall book value
was obtained through the firm’s annual report. In absence of any indication of interest rates,
an implicit rate of 3.44% was thus generated from total interest payments divided by debt
liabilities.
Employment of SVA Model:
With reference to the valuation, Tullow Oil Plc’s sales revenue of $1,606.6m (31st December
2015), was increased periodically by a growth rate of 16.46% over a 5 year planning horizon.
A -68.1% operating margin was then applied to sales revenues to arrive at the firm’s
operating profits/loss. To compute operating cash-flows, a corporation tax rate of 20% was
charged and subsequent deductions of 0.48% in incremental capital investment and 96.90%
in working capital investment were made respectively. The present value of future cash-flows

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was then approximated by discounting the firm’s operating cash-flows by 5.12% cost of
capital. The firm’s ($28,540.11m) residual value as at 6+ year was discounted twice, the first
of which determined the value at year 5, and then the value in present day terms. Adjustments
to $5,098m net present value were made by adding $762m marketable securities/cash and
then subtracting $4,336m total debt to derive Tullow Oil Plc’s intrinsic value of $38,125m.
Comparative Analysis:
Under the SVA model, the economic value of Tullow Oil Plc was determined at
$(38,125.34m whilst its market capitalisation equated to $2,766.54m. It is worth pointing out
that there may be a number of factors explaining the deficit of $40,891.88m. One such
possibility could be that share prices may not accurately reflect all relevant information to
yield a fair market value (Financial Times, 2011). Fama, (1970), in his Efficient Market
Hypothesis (EMH) champions the idea that the reliability of share prices will vary depending
upon the efficiency of the markets. In a weak-form market efficiency, a share prices will only
reflect past information pertaining to historical share price trends. If indeed, conditions did
mimic a weak-form efficiency, the market value may well lack reliability. Under a strong-
form market efficiency, the sum would present an accurate reflection of the firm’s value,
since it implies that share prices reflect all past, present and insider information (Jarrett,
2010). However, some critics have refuted this simplistic understanding. Kehneman and
Tversky, (1973) purports that due to a range of contributory factors including:
“...overreaction, representative bias, information bias, and other predictable human errors in
reasoning and information processing” (p. 12) share prices will always be prone to
inaccuracies irrespective of the degree of market efficiency. In light of the agency theory,
absence of key data due to information asymmetry between Tullow Oil Plc’s management
and its shareholders could potentially lead to ill-informed judgements on corporate value
(Adams, 1994). Considering the high-profile case of Facebook and its flotation on the
NASDAQ stock exchange. Share prices peaked £29 and swiftly plummeted to £20 after it
was exposed that Mark Zuckerberg deceived his shareholders by failing to disclose
Facebook’s struggle to achieve its optimistic growth forecasts (Levine & Stempel, 2012).
Indeed, the discrepancy between the two values may well be indicative of the binding
assumptions made under the SVA methodology. The model posits that sales will grow at
16.46% in ‘perpetuity’, an assumption clearly out of touch with the current economic reality
and perhaps over inflating the firm’s SVA valuation. Similarly, the view that WACC (5.12%)

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will remain constant throughout the 5 year planning horizon undermines any subsequent
changes that are likely to materialise in the firm’s capital structure.
Sensitivity Analysis:
Sensitivity Analysis is a measure and an extend version of SVA which ranks the value drivers
according to the most impacted value due to the variable. It can be achieved by changing any
of the input variable and the resultant output. Following a sensitivity analysis, we can deduce
that Tullow Oil Plc’s valuation of $(38,125.34)m is most susceptible to subtle changes in the
firm’s operating margins (16.46%). A negative adjustment of 2% translates into a 2.43% loss
in the firm’s underlying value. The identification of the critical variable stresses the
importance of devising strategies consistent with managing the Tullow Oil Pls’s operating
expenditure. According to the Annual Report, the firm’s operating costs are in large part,
driven by the explorations costs written off, accounting for $748.9m (Tullow Oil Plc’s
Annual Report, 2015, Note 9). Low cost per barrel oil production at locations in West Africa
can help in achieving lower exploration costs. The company expects that such projects would
benefit in achieving higher production which shall naturally reduce the operating cost to the
company. The nature of industry in which the company operates is highly unpredictable. As
it’s a global market and the demand is throughout the world, the prices are driven by the
market forces. Moreover, the company says it can take a major position in East Africa by
following strategies best in such industry.
Further, we find that WACC of 5.12% is first to operating margins, as the critical variable.
An increase of 2% in the WACC rate results in a 26.84% increase in the firm’s overall value.
In line with the Pecking Order Theory, debt should be given precedent over equity when
reaching an optimal capital structure (Donaldson, 1961). Since the firm’s cost of debt
(3.44%) is cheaper than cost of equity (8.83%), logic would dictate that Thomas Cook
secures more bank loans to finance its long-term operations, ensuring that cost of capital is
kept to a minimum. Alternatively, the firm could perhaps raise additional finance through
bond markets. In the majority of cases, bond holders are willing to fix a more lenient long-
term interest rate compared to their banking counterparts (Tanaka, 2005). Outflow of interest
would be fixed and shall not changes unless there is a change in base rate by the bank.
Corporate Financial Event:

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Funding Strategy:
Tullow Oil Plc enjoys the benefit of diversified debt structure. It has enhanced the capacity of
its RBL and corporate facilities by $450 million during the year 2015. (Tullow Oil Plc
Annual Report, Page 3). Till date the company had a net debt of $4 billion. Such debt was not
taken at one shot. It was taken over different periods. The company could have raised funding
by way of further equity capital being raised. But it chose to go for debt financing to expand
its projects. As aware, the company is a leading independent oil and gas exploration and
production company. It possesses around around 110 exploration licences across 19 countries
in the regions of West Africa and East Africa. In a statement made, Aidan Heavey, chief
executive of Tullow Oil Plc he said that the company intends to have low cost oil assets
which has production capacity of atleast 1,00,000 bopd. Also, with the latest, proven
technology, the company wants to emerge as major player in East Africa being world’s
newest and low cost oil producer.
An oil exploration company’s main source to generate revenue is having oil plants at
locations where oil can be extracted. Such places are identified and after due diligence, due
approvals are taken from Government of the respective state. Once permission granted, the
company should deploy people to build the plant. The industry in which the company
operates requires huge investment in plant and machinery. Such plant and machinery can
either be purchased out of own funds or out of borrowed funds. As the investment is huge,
100% of the proceeds cannot be funded using own sources of capital as generally no person
maintains such liquidity. In such cases, the option is to borrow money from banker.
When money is borrowed from the bank, the company is said to have been leveraged.
Leverage is a factor which helps introduction of debt funds into capital of the company
thereby giving advantages like tax benefit, lesser cost of capital etc.
There are many advantages of borrowing the money from the banker which are detailed as
below:
 Tax Benefit: When funds are borrowed from Bank, the company can enjoy the benefit
of tax by paying lower taxes. Interest is an expense which is claimed against the
profits. However, equity payments does not enjoy any such benefits of tax. This
makes the company to get attracted towards borrowed funds rather than equity funds.
As also seen from the valuation above, WACC was applied to discount the cash

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flows. WACC is combination of two components, in the above case it is of equity and
debt. Cost of Equity is higher in comparison with that of cost of debt as seen from the
computations made above. Therefore it is understood that cost of capital in the current
case is cheaper in case of debt funds. As the company is into such industry where
investment in plant and machinery is huge, it has rightly opted for debt financing.
 Easy Process for raising the capital: The debt capital can be raised in far simpler
manner in comparison to that of equity financing. Equity financing requires lot of
procedural aspects in line in addition to documentation. Comparatively the
complications are lesser in debt.
 Increased Cash Flows: Under debt financing, the amount is taken as loan initially by
receiving the down payment. The same needs to be repaid but over a period of time.
As the instalment amount are generally spread into small parts, it becomes easy for
the company to repay small portion of debt as instalment and increase its cash flows.
This cash flows can either be reinvested into the business of the company or can be
retained with itself by investing into financial instruments like Fixed Deposits, shares
or mutual funds which yields the company interest on investment. As the investment
is huge in plant and machinery, the funds requirement would be high. Debt financing
makes it easier by increasing the cash flows thereby resulting in expanding the
projects of the company for its successful implementation.
 Improvement in Credit Rating: The company repays its debt liability in instalments.
This has an emotional impact on the bankers. Due to timely payment of instalments
along with the interest, the company earns itself a good reputation. Due to such
goodwill, the credit rating of company improves resulting in achieving loans for
further expansion at competitive rates or cut down in rates of interest on the existing
loans.
 Magnification of shareholder’s earnings: Debt financing in a way has impact also on
the shareholder’s earnings. Had it been purely equity financing, the profits would be
higher resulting in higher taxes thereby reducing the shareholder’s profit. But in debt
financing, the shareholder takes a bigger portion either by way of dividend or wealth
creation.

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 Retaining Business Ownership: Under equity financing, the ownership lies with
various business owners therefore collective decision needs to be taken. Some of the
decisions may not be favourable a to set of investors. Whereas in debt financing, no
ownership is handed over to the finance provider. It is just the hypothecation of the
assets of the company in order to safeguard banker’s interest against bankruptcy.
While deciding, on considering the advantages, the disadvantages should not be ruled out as
these also affect the decisions:
 Interference in the decisions: Many a times it happens so that the banker in order to
protect its interest in case any default is committed. Such interference may disturb the
objectives/ goal of the company to accomplish.
Impact on Company’s strategy:
The strategy of company to expand its operations with the use of debt finance shall leave a
positive impact on the shareholders of the company. This is due to the fact that the objective
with which the company is incorporate can be realized. As discussed above under the
valuation model, the proportion of debt if increased shall directly impact on cost of capital of
the company. The cost of debt was lower in comparison with the cost of equity. This would
help the company in reducing the financial costs and take advantage of leveraging by way of
reduction in tax liability.
Value of the company:
In case of the company cost of debt is cheaper. Higher proportion of debt in the capital would
directly impact the cost of capital. The cost of capital would come down as the proportion of
debt is higher and the cost of debt is lower. Due to lower cost of capital, the discounting
factor would be smaller thereby ultimately increasing the value of the company.
Strategic Position by the company:
Company has wide number of oil exploration sites where the process is in full swing. The
company is in stage of setting up the oil exploration plants at many places in East Africa and
West Africa. Funds borrowed from the bank can be utilised for payment towards construction
of plant. The company expects the plant to be complete by the year 2018. Till then the

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company also plans to renew the capital upon expiration. After the oil exploration site is
ready, commercial operations can be started which shall generate revenue to the company on
sale of oil products like petrol/diesel etc.
International Capital Investment:
On successful implementation of the oil exploration plant, the company may also received
capital from international investors. This is a good news to Government as such inflow of
funds would increase Government’s foreign exchange reserves.
CONCLUSION:
On basis of valuation and other factors discussed above, it seems that the company is still in
its probationary stage and shall require time to start generating profits. The company’s trends
in was not attractive. However, the only reason for which the investors may invest is the
expansion of the projects of oil exploration. The projects seems to be promising as the
projects in East Africa has been successful.
References

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