(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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(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.

Expert Answer


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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