A petroleum project involves production of crude oil from a 5,000,000 barrel reserve. Time zero mineral rights acquisition cost (lease bonus) of $2,000,000 is the basis for cost depletion. Intangible drilling expenses of $1,500,000 will be incurred in time zero. Tangible producing equipment costing $3,000,000 at time zero will go into service in year one and depreciated using double declining balance (on the 7-year depreciation basis considering first full year of use) Production is estimated to be 350,000 barrels per year. Well-head crude oil value before transportation cost is estimated to be $42.00 per barrel in year one, $43.00 per barrel in year two, and $44.00 per barrel in year three. Royalties are 10.0% of revenues (well-head value) each year. Operating costs are expected to be $3,000,000 in year one. $3,300,000 in year two, and $3,600,000 in year three. The allowable percentage depletion is 15.0%. The effective income tax rate is 40.0%. The investor has other taxable income against which to deduct negative taxable income (No Carry forward is allowed). Determine the after-tax cash flows for years 0, 1, 2, and 3.
Expense 100% of intangible drilling costs at the end of first year; Use the larger of percentage depletion (subject to limit rules) and cost depletion.
Transcribed Image Text:4. A petroleum project involves production of crude oil from a 5,000,000 barrel reserve. Time zero mineral rights
acquisition cost (lease bonus) of $2,000,000 is the basis for cost depletion. Intangible drilling expenses of $1,500,000
will be incurred in time zero. Tangible producing equipment costing $3,000,000 at time zero will go into service in year
one and be depreciated using double declining balance (on the 7-year depreciation basis considering first full year of
use). Production is estimated to be 350,000 barrels per year. Well-head crude oil value before transportation cost is
estimated to be $42.00 per barrel in year one, $43.00 per barrel in year two, and $44.00 per barrel in year three.
Royalties are 10.0% of revenues (well-head value) each year. Operating costs are expected to be $3,000,000 in year
one, $3,300,000 in year two, and $3,600,000 in year three. The allowable percentage depletion is 15.0%. The effective
income tax rate is 40.0%. The investor has other taxable income against which to deduct negative taxable income (No
Carry forward is allowed). Determine the after-tax cash flows for years 0, 1, 2, and 3.
Expense 100% of intangible drilling costs at the end of first year; Use the larger of percentage depletion (subject to limit
rules) and cost depletion.
Definition Definition Net amount of cash that an entity receives and expends over the course of a given period. For a business to continue operating, positive cash flows are required, and they are also necessary to produce value for investors. Investors in particular prefer to see growing cash flows even after capital expenditures have been paid for (which is known as free cash flow).
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