Reference no: EM131552946

Suppose an oil company is considering whether to develop production facilities for a newly discovered oil field on lands owned by a state government. If the firm spends $1 billion in present value of capital costs, it could install facilities capable of producing 40,000 barrels per day. Annual operating costs for the oil field are anticipated to be $25 per barrel produced. The company expects production from the field to start at 40,000 barrels per day but then decline at 10 percent annually indefinitely. The firm has to pay its investors a 8 percent annual return.

1. The company has to pay royalties to the landowner at a rate of one-eighth (12.5%) of gross revenues. The state currently levies a a production tax at a rate of 35 percent of before-tax profits. What are (1) expected total taxes, (2) expected total royalties, (3) expected total developer after-tax profits, and (4) expected economic rent, all expressed as present discounted values?

2. The firm's managers are risk averse and decide to make their investment decisions based not on the anticipated oil price but rather on profits that would result if the oil price were $45 per barrel. Would the company decide to make the investment?

3. The state government is facing a budget deficit due to low oil prices, and is considering changing its tax regime by replacing the production tax based on 35 percent of before-tax profits with a tax based on 10 percent of the company's share of gross revenues, i.e., 10 percent of 7/8 of gross revenues. Which tax would be likely to yield more revenues? Show your calculations and explain your reasoning.