(a) Complete Table 2.6 and show that the total depletion allowance exceeds the original investment. (b) Calculate the PV and the IRR for this investment. Assume an interest rate of 20%.
(a) Complete Table 2.6 and show that the total depletion allowance exceeds the original investment. (b) Calculate the PV and the IRR for this investment. Assume an interest rate of 20%.
Chapter10: The Basics Of Capital Budgeting: Evaluating Cash Flows
Section: Chapter Questions
Problem 14P
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Question
![TABLE 2.6
OIL INVESTMENT DETAILS
Year
12345
12. (Oil depletion allowance )
A wealthy investor spends $1 million to drill and develop
an oil well that has estimated reserves of 200,000 barrels. The well is to be operated over
5 years, producing the estimated quantities shown in the second column of Table 2.6. It is
estimated that the oil will be sold for $20 per barrel. The net income is also shown.
Barrels
Gross
produced revenue
30,000
10,000
80,000
70,000
50,000 1,000,000 500,000
200,000
50,000
1,600,000
400,000 1,000,000
Net
Depletion Taxable
income Option 1 Option 2 allowance income
400,000
400,000
1,200,000 352,000
600,000
200,000
After-tax
Tax
income
800,000 360,000 840,000
A depletion allowance, for tax purposes, can be computed in either of two ways each
year: 22% of gross revenue up to 50% of net income before such deduction (option 1), or
the investment cost of the product, equal in this case to the unit cost of the reserves, $5 per
barrel (option 2). The allowance is deducted from the net income to determine the taxable
income. The investor is in the 45% tax bracket.
(a) Complete Table 2.6 and show that the total depletion allowance exceeds the original
investment.
(b) Calculate the PV and the IRR for this investment. Assume an interest rate of 20%.](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2F1341decc-8dec-4d41-bf9b-f8cce7b2aabd%2F5be47875-ca40-414b-85a8-e0a033dbbe41%2Fw4sv4ol_processed.jpeg&w=3840&q=75)
Transcribed Image Text:TABLE 2.6
OIL INVESTMENT DETAILS
Year
12345
12. (Oil depletion allowance )
A wealthy investor spends $1 million to drill and develop
an oil well that has estimated reserves of 200,000 barrels. The well is to be operated over
5 years, producing the estimated quantities shown in the second column of Table 2.6. It is
estimated that the oil will be sold for $20 per barrel. The net income is also shown.
Barrels
Gross
produced revenue
30,000
10,000
80,000
70,000
50,000 1,000,000 500,000
200,000
50,000
1,600,000
400,000 1,000,000
Net
Depletion Taxable
income Option 1 Option 2 allowance income
400,000
400,000
1,200,000 352,000
600,000
200,000
After-tax
Tax
income
800,000 360,000 840,000
A depletion allowance, for tax purposes, can be computed in either of two ways each
year: 22% of gross revenue up to 50% of net income before such deduction (option 1), or
the investment cost of the product, equal in this case to the unit cost of the reserves, $5 per
barrel (option 2). The allowance is deducted from the net income to determine the taxable
income. The investor is in the 45% tax bracket.
(a) Complete Table 2.6 and show that the total depletion allowance exceeds the original
investment.
(b) Calculate the PV and the IRR for this investment. Assume an interest rate of 20%.
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