Question

The XYZ Company develops oil wells in unproven territory. • A consulting geologist has reported that there is a one-in-four chance of oil on a particular tract of land. • Drilling for oil on this tract would require an investment of about $100,000. • If the tract contains oil, it is estimated that the net revenue generated would be approximately $900,000. • Another oil company has offered to purchase the tract of land for $90,000. Question: a. Should XYZ drill for oil or sell the tract? Please draw the decision tree model, provide the calculation and final decision. b. If the probability of the land containing oil becomes 15%, drill or sell? Please draw the decision tree model, provide the calculation and final decision.

Answer 1

Answer: Q: No oil co.75 ) Drill for oil oil (0:25) $ 900000 sell the track $90000 Expected value = Sprobability x pay off For brill for oil Expected value = 0.75 40+0.25X900000 =$225000 Investment = $ 100 000 Net probit $225.000-$100000 $125000 Nel- pootit for sell the track = $90000

since net probit of drill for oil is higher, therefore best decision is to drill for oil. $0 b. No oil 0.85) oil (0.15) Drill for oil $ 900000 sell the tract $ 90000 Expected value = E poobability x payoff For Doill for oil Expected value 0.85 X0 +0.15 X 900000 $135000 drivestment $ 100 000 Net probit = $135000 - $100000 $ 35000

Net probit for sell the tract = $90.000 Since net poobit of sell the tract is higher, there bore best decision is tos Sell the tract.