University of Dar es

Salaam
OG 405
Petroleum Project Evaluation
&
Economics

LECTURE 4
AFTER-TAX CASH FLOW MODELING
BY: Fulmence Kaborogo(MSc.PE)
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Project Cash Flow Framework
Lecture 3

Lecture 4
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After-Tax Cashflow Models
❑Taxes is among the disbursement that must be
included in the economic evaluations.
─its inclusion in investment analysis increases its
complexity, as requires an understanding of the fiscal
terms (tax law and structures) under the licensed area
─and sometimes incorporating taxes in the economic
evaluation may reverse the decisions based on the
before-tax cash flows.
─Thus, all investment decisions must be on the net
after-tax cash.
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Developing after-tax-Cash Flows
❑For tax purposes, tax-deductible items must be
subtracted from the EBITDA.
─these items include interest payments (I) on debt,
depreciation, depletion, and amortization expenses
(DD&A).
─The resulting value refers to taxable income.
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Developing after-tax-Cash Flows
─after-tax income is calculated by subtracting the tax
payable from the taxable income
─Then, tax-deductible items DD&A, IDCs, and interest
are added back to the after-tax income to arrive at
the net after-tax cash flow.
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Depreciation

Depreciation
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Depreciation
❑Depreciation refers to the gradual and permanent
decrease in value of a firm, nation, or individual over
its lifetime.
─Other words, it is that loss in the value of an asset over
the time as it is being used.
─It begins from the time the property is placed in for
use in for the production of income;
─stopped when the cost or other basis of the property is
recovered or when it is retired. (i.e., permanently
withdrawn from use in trade or business) from service.
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Depreciation

The cost of a property is fully recovered when its

depreciation deductions are equal to the cost or
investment in the project.
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Depreciation
• A method of allocating the cost of a tangible asset over
its useful life.
• Businesses depreciate long-term assets for both tax
and accounting purposes.
• Another reason for depreciation is that without it,
fixed assets in the balance sheet will be overstated.
• For example, the market value of a 5-year-old piece of
equipment is not worth the same as when it was
purchased brand new.
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Depreciation
• Most importantly, depreciation is a deductible non-
cash expense for income tax purposes.
✓ The higher the depreciation allowance being
deducted in any given year, the lower the taxable
income.
✓ Tax deductibility of depreciation decreases the
firm's tax liability.
✓ Therefore, its inclusion in calculating the projects'
after-tax cash flow is essential.
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Depreciation
• For a property to be depreciable, it must be:
✓ used in business or held to produce income.
✓ have a determinable useful life longer than one year.
✓ something that is subject to wearing out, decaying being
used up, becoming obsolete, or losing its value from
natural causes.
✓ something whose value can be increased, or made more
useful, or lengthened its life through repair or
replacement.
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Estimation for Asset Depreciation
In order to calculate depreciation, four values are needed;
✓ Initial cost of the asset;

✓ Expected salvage value of the asset (which refers to the

value of the asset when it can no longer be used in
production).

✓ Estimated useful life of the asset;

✓ A specific method of apportioning the cost of over the

life.
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Methods of Calculating Depreciation
Common methods include;
✓Straight line method
✓declining balance method
✓Double declining balance method
✓Sum of the years’ digit method
✓Unit of production method
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Straight line method
• Straight line depreciation is the most often used technique and
also the simplest.

• In this method, the depreciable cost or cost basis of the

property is equally distributed over the useful life of the asset

• The depreciation is calculated as:

✓ where Dn is the depreciation in an nth year, C is the total cost of the

depreciable asset, Sv is the salvage value, and n is the useful life of the
asset. Straight-line
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Straight line method
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Straight line method
Example:
An item of equipment acquired on January 1 at a cost
of $100,000 has an estimated life of 10 years.
Assuming that the equipment will have a salvage value
of $10000, determine the depreciation for each of the
first three years.
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Straight line method
SOLUTION:
Number of 1 2 3
years
Opening Book 100000 91000 82000
value
Depreciation 9000 9000 9000
Ending Book 91000 82000 73000
value
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Straight line method
• Companies frequently use different accounting methods
for public financial statements versus tax returns.

• Since the straight line method results in lower deduction

amounts in the early years, it could overstate a
company’s income.

• But, of course, a company wants its income statement to

look good to external parties, so the straight-line method
is acceptable for public reporting.
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Declining balance method
❑Sometimes, the method is also referred to as the
accelerated depreciation method.
❑ In this method, a fixed depreciation rate is applied to
the book value of the asset each year.
─The depreciation rate is calculated by dividing the
decline Balance percentage by the recovery period
assigned to the asset.

DBD = 𝒅𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 𝒓𝒂𝒕𝒆 × 𝒂𝒔𝒔𝒆𝒕 𝒃𝒐𝒐𝒌 𝒗𝒂𝒍𝒖𝒆

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Declining balance method
─The decline balance percentages could be 200% DB
(referred to as double decline balance), 175% DB,150%
DB, and 125% DB.
─Under the DB method, the depreciation deduction
stops when the book value equals the estimated
salvage value.
─ Note that the DB calculations do not consider salvage
value and are calculated on the basis of each year's
ending book value.
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Declining balance method
Example:
An item of equipment acquired on January 1 at a cost
of $100,000 has an estimated life of 10 years.
Assuming that the equipment will have a salvage value
of $10000, determine the depreciation for each of the
first three years using the DDB method.
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Declining balance method
SOLUTION:
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Straight Line vs Decline Balance
─In some cases, the DB results in lower deduction
amounts than the straight line, potentially
overstating a company’s income.
─In such a situation , it is allowed to switch to straight-
line depreciation in the year when this method
provides greater deduction over the declining
balance.
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Straight Line vs Decline Balance
EXAMPLE
Calculate 200% declining balance depreciation and
switching to straight line when feasible for a
pumping unit acquired at a cost of $35,000 with a
salvage value of $5,000 at the end of its useful life of
5 years.
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Straight Line vs Decline Balance-best practices
SOLUTION:
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A sum of the years’ digit method
─This method produces a declining depreciation charge
each year by applying a declining depreciation rate to
the value of the asset for the tax year.
─The declining depreciation rate is determined each
year by dividing the remaining life of the asset by the
sum of the years' digits (SYD).
─Clearly, the annual depreciation is higher towards the
beginning of the project because this is when the
remaining life is longer.
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A sum of the years’ digit method

✓ where AD is the annual depreciation amount, SYD is the sum of years'

digits, and n is the useful life of the asset to be depreciated
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A sum of the years’ digit method

Example:
An item of equipment acquired on January 1 at a cost
of $100,000 has an estimated life of 10 years.
Assuming that the equipment will have a salvage value
of $10000, determine the depreciation for each of the
first three years using the Sum of the years’ digit
deprecation method.
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A sum of the years’ digit method
SOLUTION: 𝟏𝟎(𝟏𝟎 + 𝟏)
𝐒𝐘𝐃 = = 𝟓𝟓
𝟐
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Units of Production Depreciation
─This method is used when it is determined that the life
of the asset is dependent on how much the asset is
used or units it produced, rather than the passage of
time.

─The units-of-production depreciation method

depreciates assets based on the total number of hours
used or the total number of units to be produced by
using the asset, over its useful life
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Units of Production Depreciation
─The depreciation charge for each year is calculated by
multiplying the activity per period by the depreciation
rate.

─Where as the rate is calculated as:

─The activity may be measured in hours, days, months,

years, or the number of items produced.
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Units of Production Depreciation
Example:
An item of equipment acquired on January 1 at a cost
of $60000 has an estimated use of 25000 hours.
During the first three years, the equipment was used
5000 hrs, 6000 hrs and 4000hrs, respectively. The
estimates salvage value of the equipment is $10000
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Units of Production Depreciation
SOLUTION:
$𝟔𝟎,𝟎𝟎𝟎−$𝟏𝟎,𝟎𝟎𝟎
Depreciation rate= = $ 𝟐. 𝟎 𝐩𝐞𝐫 𝐡𝐨𝐮𝐫
𝟐𝟓𝟎𝟎𝟎
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Depletion & Amortization (DA’s)

Depletion and
Amortizable
Allowances
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DEPLETION
─Depletion is the gradual exhaustion of the original
amounts of the resources acquired.
─It refers to the allocation of the cost of natural
resources over time such as minerals, oil, natural gas,
timber, etc.
─Other Items included in the depletable basis for cost
depletion are geological and geophysical (G&G) costs
lease bonus paid by the lessee, and capitalized
intangible costs not represented by physical property.
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DEPLETION METHODS
─The two basic forms of depletion allowance are
percentage depletion and cost depletion
─The percentage depletion method allows a business to
assign a fixed percentage of depletion to the gross
income received from extracting natural resources
─Figured out by multiplying a certain percentage,
specified for each mineral, by gross income from the
property during the tax year.
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Percentage Depletion Allowance
Deduction for percentage depletion cannot be more
than the smaller of:
─taxable income from the property figured without the
deduction for depletion, or
─50% of your taxable income from the property, figured
without the depletion deduction.
─65% of your taxable income from all sources figured
without the depletion allowance, any net operating
loss carryback, and any capital loss carryback.
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Percentage Depletion Allowance
─Percentage depletion is applicable to independent
producers and royalty owners (15% allowed),
regulated natural gas and for gas sold under a fixed
contract or produced from geopressured brine
(22% allowed)
─If qualify for percentage depletion and it is less than
the cost depletion for any year, must use cost
depletion for that year.
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Cost Depletion Allowance
─Cost depletion is figured out by dividing the adjusted
basis of the mineral property by the total recoverable
units in the property's natural deposit.
─Then multiply the resulting rate per unit by units
sold.
─cost depletion can be represented by.
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Cost Depletion Allowance
where AB is the adjusted basis for the taxable year,
─Q is the number of units sold during the year, and
─Rr is the number of remaining reserves at the end of the
taxable year.
─The adjusted basis equal original cost or other basis plus any
capitalized costs, minus all the depletion allowable on the
property
─The total recoverable units is the number of resources
remaining at the end of the year plus the sold during the tax
year.
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Depletion Allowance
Example:
It is estimated that a taxpayer has remaining reserves
(net to his interest) at the end of his tax year of 50,000
barrels of oil. His production share in the year was 6000
barrels sold at $18 per barrel. His net taxable income
before depletion from the property was $80,000 and
the taxpayer's total taxable income was $450,000.
Compute the appropriate depletion charge for the year.
The adjustable bases of the capitalized leasehold costs
are $45,000
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Depletion Allowance
Solution:
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Depletion Allowance
Solution:
• Therefore, the allowable percentage depletion is $16,200
since the percentage depletion is greater than the cost
depletion of $4,821.

Quiz!
What will be the adjusted basis and remaining
reserves for next year?
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Intangible Drilling Costs (IDCs)
─Intangible drilling costs are defined as costs related
to drilling and necessary for the preparation of wells
for production, but that have no salvageable value.

─These include costs for wages, fuel, supplies, repairs,

survey work, and ground clearing.

─They compose roughly 60 to 80 percent of total

drilling costs.
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Intangible Drilling Costs (IDCs)
─In the U.S, the independent producer may elect to
expense 100% of IDCs in the year incurred for
domestic wells.

─For foreign IDCs, the cost may be recovered over a

10-year period using straight-line amortization or
may be added to its depletable basis.

─However, the terms may vary between countries.

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Intangible Drilling Costs (IDCs)
─In the U.S, the integrated producer may elect to
expense 70% of IDCs in the year they were incurred
and amortize the remaining 30% over 60 months for
domestic wells.

─The foreign IDCs must be capitalized over a 10-year

period using straight-line amortization or may be
added to its depletable basis

─Dry hole costs may be expensed in the year incurred,

regardless of the way the IDCs are treated.
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Asset Amortization
─This is the practice of spreading an intangible asset's
cost over that asset's useful life.
─unlike with depreciation, assets that are expensed
using the amortization method typically don't have
any resale or salvage value.
─Includes start-up costs and organizational expenses
for the corporation.
─Such as Costs for a survey of a potential market;
analysis of available facilities, labor supply.
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Asset Amortization
─Amortizable costs, must have been paid or incurred
before the day the active trade or business begins.
─Unlike depreciation, amortization is typically
expensed on a straight-line basis for a period of 60
months or more.
─Additionally, assets that are expensed using the
amortization method typically don't have any resale
or salvage value, unlike with depreciation.
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After-Tax-Cash Flow Framework
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Loan Amortization (Interest)
─Involves paying off a debt, normally gradual retirement
of debt with a series of equal periodic payments for
the loan.

─The loan payment is calculated using an annuity

formula, split into interest accrued on the outstanding
loan balance and principal amount.

─Simple interest is used to calculate the accrued

interest on the outstanding loan balance for the year
in question.
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Loan Amortization (Interest)
─An amount P today (e.g. a loan) can be repaid in N
Equal terms A, interest included, according to the
following equation;

 i(1+ i)  N
A = P 

 (1+ i) − 1
N

─The Annuity consists of Principal repaymet and

Interests.
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Calculating Interests
Example:
An oil producer borrows $100,000 at an interest rate of
8% for a period of three years. The loan has to be paid
back quarterly over the three-year period, with the first
payment due exactly three months from the date
money is borrowed. Calculate the quarterly payments
and interest payable each year.
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Calculating Interests
Loan
amortization
schedule
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Petroleum Taxation
There are various types of resource taxes, the major
ones being;

❖Direct tax instruments:

─Corporate income tax plus capital gains tax
─Resource rent taxes
─Brown tax, cash flow tax with government subsidy
─Production profits tax, additional profit tax, super-
profit tax, net profits, royalties etc. ,
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Petroleum Taxation
There are various types of resource taxes, the major
ones being;

❖Indirect tax instruments

─Ad valorem, specific/production volume royalties
─Import duties, export duties
─VAT, sales tax
─Property or capital taxes, stamp duties
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Petroleum Taxation
There are various types of resource taxes, the major
ones being;

❖Non-tax instruments:
─Competitive bonus bidding, auctions (e.g.,
hydrocarbons)
─Surface or usage fees
─Production sharing contracts
─State equity participation
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Calculating Petroleum Taxes
─The taxes for each accounting period is calculated
based on the agreed framework between the country
and E&P companies.
─Mostly referred to fiscal regime or fiscal system.
─This system is governed by a nation's economic policy,
and legislations which comes from decisions made by
the governing body.
─The fiscal regime or fiscal system includes all aspects of
legislative, taxation, contractual, and fiscal elements.
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Fiscal system & Hydrocarbon Taxation
─In practice the a host government grants license or
enters into a contract with a contractor for a given
contract area.
─The government as the owner of resources engages a
E&P company to provide technical and financial
resources for exploitation of these resources.
─The host government is represented by either a
national oil company, an oil ministry of the country, or
both.
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Fiscal system & Hydrocarbon Taxation
─The contractor bears all exploration costs, field
development costs, operating costs, and risks in
return for a stipulated share in the resulting
production from the field.
─Where's as the government earns through various
taxes, royalty, bonus, license fees as a result of the
activities in the con tract area.
─This all depends on the structure of the fiscal system
in place.
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Forms of Fiscal Systems
─Two basic forms of fiscal systems exits:
Concessionary Systems and Contractual Systems.
─Concessionary system, also referred to as tax/royalty
system allows private ownership of
mineral resources.
─ Whereas, in the contractual system, the
government retains ownership of minerals.
─The major difference in either case is how costs are
recovered, risks shared, and profits divided.
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Concessionary Systems
• Licence issued by the responsible Ministry.
• Hydrocarbons are extracted by the companies normally and they
pay royalties and taxes to the government of the country where
they operate.
• Financial Obligations.
– Royalty payments (cash or kind)
– Production Levy & Impost
– Signature/Production Bonus
– Import duties
– Income taxes paid by the Company directly to the BIR (Bureau of Internal
Revenue)
– Other payments as may be appropriate
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Contractual Systems.
─The contractual systems are further reclassified into
service contracts and production-sharing
contracts (PSC).
─The primary difference here is whether the fee is
taken in cash (service) or in kind (PSC).
─The production-sharing contract is also referred to
as the production-sharing agreement (PSA).
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Production Sharing Agreement (PSA)
─PSCs developed in Indonesia in 1960s, but now quite common
in oil-producing countries
─The operator company is contracted to develop resources.
─Many aspects of the government/contractor relationship
under a PSA may be negotiated but some are fixed.
─The basic structure is effectively predetermined by the
legislation of the host government.
─Typically, model PSAs are put forward by the host government
as a basis for bidding and negotiations.
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PSA SHARING MECHANISM:SUMMARY
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Food for Thought.
─Which contract type is Tanzania using?
─Which contract type is more effective??
─What fiscal terms in MPSA would significantly
affect the government take?
─What combination of fiscal terms in MPSA
would result in a balance between government
take and contractor take? Not so obvious.
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THE END