The question is: which will make the block of wood go higher? The bullet in the center of the block or off center?
Both achieve the same high (conservation of momentum).
There is certainly energy associated with the spinning of the block. The kinetic energy is not conserved during this collision, but the total energy is. The internal energy associated to each block is different (in each block we have thermal energy and deformation energy). So, the block 2 will have the same translational kinetic energy as block 1 by a lower change in internal energy (the bullet causes less thermal energy and deformation to the second block, and it increase in rotational kinetic energy).
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