A local energy provider offers a landowner $180,000 for the exploration rights to natural gas on a certain site and the option for future development. This option, if exercised, is worth an additional $1,800,000 to the landowner, but this will occur only if natural gas is discovered during the exploration phase. The landowner, believing that the energy company’s interest in the site is a good indication that gas is present, is tempted to develop the field herself. To do so, she must contract with local experts in natural gas exploration and development. The initial cost for such a contract is $300,000, which is lost forever if no gas is found on the site. If gas is discovered, however, the landowner expects to earn a net profit of $6,000,000. The landowner estimates the probability of finding gas on this site to be 60%.
a. Create a payoff table that specifies the landowner’s payoff (in dollars) associated with each possible decision and each outcome with respect to finding natural gas on the site.
b. Use PrecisionTree to identify the strategy that maximizes the landowner’s expected net earnings from this opportunity.
c. Perform a sensitivity analysis on the optimal decision, letting each of the inputs vary one at a time plus or minus 25% from its base value, and summarize your findings. In response to which model inputs is the expected profit value most sensitive?
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