Question

Xon, a small oil equipment company, purchased a new petroleum drilling rig for $2,000,000. Xon will depreciate it using MACRS depreciation. The drilling rig has been leased to a firm, which will pay Xon $750,000 per year for 8 years. After 8 years the drilling rig will belong to the firm. Xon has a 28% combined incremental tax rate and a 20% after-tax MARR (a)Does the investment appear to be satisfactory?

Answer 1

To determine if Xon's $2,000,000 investment in a drilling rig is satisfactory, one must calculate the after-tax cash flows from lease payments and MACRS depreciation benefits, and compare the net present value of these cash flows against the 20% after-tax MARR.

Step-by-step explanation:

To assess whether Xon's investment in the new petroleum drilling rig is satisfactory, we should consider the cash flows associated with the investment, including the annual lease payments, the cost of the rig, and the tax benefits from MACRS depreciation.

Over the 8 years, Xon will receive $750,000 annually, totaling $6,000,000 in lease payments. Although the rig costs $2,000,000, Xon can take advantage of the tax savings from depreciation which will reduce its tax liability based on its 28% tax rate.

Additionally, the least payments are subject to taxes. To evaluate the investment, we need to calculate the after-tax cash flows and compare them to the initial cost accounting for the after-tax MARR of 20%, which is Xon's required minimum acceptable rate of return.

By performing a net present value (NPV) analysis or other capital budgeting analysis and comparing it to this MARR, we can determine the investment's profitability.