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.
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.
B) Using the incremental free cash flows from part (A), calculate the NPV and IRR of the well, assuming at 15% annual discount rate.