Equipment Purchase and Maximum Price Decision: Transcontinental Oil Company has some oil properties that are now at the point where further production is not worthwhile without better equipment. Even with the better equipment, the properties would be economically productive for only six more years. If Transcontinental Oil Company decides to buy the equipment, it will enter into a contract at Time to purchase the equipment. The supplier of the equipment has made an initial offer of a contract that calls for a payment of $2 million. The company's management believes it can reduce this price by negotiating with the supplier. For tax purposes, 40 percent of the cost of the equipment could be deducted at the end of Year 1 . This is true whether the amount paid is $2 million or some other amount. The remaining 60 percent would be depreciated on a straight-line basis over five years (Years 2-6). The equipment purchase contract also has a provision that calls for the manufacturer of the equipment to do additional work at the end of Year 2. The contract specifies a payment of $1 million to be made at that time for this service. All of this Year 2 payment would be deductable for tax purposes at the end of Year 2. Production expectations, prices of crude oil per barrel, and variable costs of production are as follows:

Both the prices per barrel of crude oil and variable costs are based on Time 0 prices. It is expected that the value of the properties at the end of Year 6 will be zero. The tax rate for the company is 40 percent. '

Required:

a. Ignoring the effects of inflation and assuming a desired after-tax rate of return of 15 percent, should Transcontinental buy the equipment for $2 million?

b. What is the amount that Transcontinental would be willing to pay for the equipment to make the NPV of the project equal to zero?

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Per Barrel Expected Production Vari- able Year (barrels) Price Costs 12345 40,000 $18 $3 70,000 18 60,000 18 50,000 18 5 40.000 18 6 30,000 18 233333