# (Solved Homework): In this question we will use our model of calculating incremental free cash flow and the proj…

In this question we will use our model of calculating incremental free cash flow and the project decision metrics discussed in class to evaluate a prospective oil well. A typical oil well in the Bakken shale formation costs around \$5 million to drill, and requires \$500,000 in site preparation and engineering service costs prior to drilling. Assume that the revenues from the well are \$1.2 million per year and operating costs are \$200,000 per year. The \$5 million capital cost of the well is depreciated using the straight-line method over a period of five years.

Note: You may use the Excel template on Canvas for calculating free cash flow but you need to explain the steps you take in your calculations. Do not simply copy and paste the Excel template without some accompanying explanation of how you made your calculations.

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(Solved Homework): In this question we will use our model of calculating incremental free cash flow and the proj…
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(A) Calculate the incremental free cash flow for the well using the following additional assumptions:
• The corporate tax rate is 40%.
• The capital cost and engineering study costs are incurred in Year 0, and the well produces in years 1 through 5.
• In calculating net working capital, assume that accounts receivable are 10% of revenues in years 1 through 4 and 5% of revenues in year 5; and that accounts payable are 15% of costs in years 1 through 3, 10% of costs in year 4, and 30% of costs in year 5.
• Don’t forget that the engineering study costs yield a tax reduction benefit in year 0, like the example we did in class!
(B) Using the incremental free cash flows from part (A), calculate the NPV and IRR of the well, assuming at 15% annual discount rate.

 Answer A Calculation of Incremental cash flow from the oil well Year 1 2 3 4 5 Revenues \$1,200,000 \$1,200,000 \$1,200,000 \$1,200,000 \$1,200,000 Operating Costs -\$200,000 -\$200,000 -\$200,000 -\$200,000 -\$200,000 Depreciation -\$1,000,000 -\$1,000,000 -\$1,000,000 -\$1,000,000 -\$1,000,000 Operating Income \$0 \$0 \$0 \$0 \$0 Cosrporate tax @ 40% \$0 \$0 \$0 \$0 \$0 Net Income \$0 \$0 \$0 \$0 \$0 Depreciation \$1,000,000 \$1,000,000 \$1,000,000 \$1,000,000 \$1,000,000 Incremental Cash flow \$1,000,000 \$1,000,000 \$1,000,000 \$1,000,000 \$1,000,000 Answer B Calculation of NPV and IRR Year 0 1 2 3 4 5 NPV Oil well formation cost -\$5,000,000 Site preparation and Engineering study cost -\$500,000 Tax saving due to Site preparation and Engineering study cost \$200,000 Working Capital needs -\$90,000 -\$10,000 Working Capital recovered \$100,000 Incremental Cash flow \$1,000,000 \$1,000,000 \$1,000,000 \$1,000,000 \$1,000,000 Net Cash flow -\$5,390,000 \$1,000,000 \$1,000,000 \$990,000 \$1,000,000 \$1,100,000 Discount Factor @ 15% 1 0.86957 0.75614 0.65752 0.57175 0.49718 Present Values -\$5,390,000 \$869,565 \$756,144 \$650,941 \$571,753 \$546,894 -\$1,994,702 NPV -\$1,994,702 IRR -1.86% Calculation of working capital needs in years 1 through 5 Year 1 2 3 4 5 Accounts Receivables \$120,000 \$120,000 \$120,000 \$120,000 \$60,000 Accounts Payable -\$30,000 -\$30,000 -\$30,000 -\$20,000 -\$60,000 Working Capital \$90,000 \$90,000 \$90,000 \$100,000 \$0

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