Petroleum Drilling, Inc., is considering installation of a new automated drillin

Question

Petroleum Drilling, Inc., is considering installation of a new automated drilling equipment. The new equipment can be installed for $12,850,000 today and will have a life of 4 years until technological obsolescence due to rapid advances in drilling control technology. At the end of its 4 year life, its components will have a salvage value of $2,500,000, and it will cost $712,500 to have the equipment removed. The equipment will be depreciated under MACRS. The equipment will produce $8,975,000 additional sales capacity per year due to productivity gains. Additional technical labor cost will be $2,305,000 per year and operating and maintenance costs will be $885,000 per year. The company is in a western state with no corporate income taxes and is in the 35% federal tax bracket. Estimate both the annual net income and annual cash flow. The company’s MARR for this project is 20.0%. Based on net present value estimate, do you recommend installing the automated refining line? What is the equivalent uniform annual worth, and IRR of the project?

Explanation / Answer

Working notes:

(a) MACRS depreciation schedule as follows:

(It is assumed that the equipment falls under MACRS 5-year property class).

(b) Annual total cost (TC), years 1 to 3 = Labor + Operating cost = $(2,305,000 + 885,000) = $3,190,000

(c) In year 4, TC will increase by $712,500 (Removal cost) and Revenue will increase by $2,500,000 (Salvage).

(It is assumed that salvage value is taxable at normal rate, and removal cost will be treated as a normal cost)

(d) Annual pre-tax net income (NI) = Revenue - TC - Depreciation

(e) Post-tax NI = Pre-tax NI x (1 - tax rate) = Pre-tax NI x (1 - 0.35) = Pre-tax NI x 0.65

(f) After-tax cash flow (ATCF), years 1 to 4 = Post-tax NI + Depreciation (which is added back, being non-cash expense)

In year 0, ATCF = - First cost

(g) NPV = Sum of all real cash inflows and outflows discounted at 20%

(h) Relaxation/change in assumptions made will result in different NPV.

(i) IRR is computed using Excel built-in IRR function.

(1) Net income & cash flow

(2) NPV & IRR

Since NPV is negative, installation is not recommended.

NOTE: First 2 questions are answered.

Year Depreciation base ($) Depreciation rate (%) Annual depreciation ($) (A) (B) (C) = (A) x (B) 1 128,50,000 20 25,70,000 2 128,50,000 32 41,12,000 3 128,50,000 19.2 24,67,200 4 128,50,000 11.52 14,80,320

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