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 $190,000 . If the tract containsoll, 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 all becomes 15%. drill or sell? Please draw the decision tree model, provide the calculation and final decision

Answer 1

1.

Decision tree corotons oil (357.) (-100000) = revenue - 900000 NPV = 900000-100006 - 800000 Doill Do not contain oil (751) - NPV = -100000 sell NPV-90000

If Drill

a.NPV if Contains oil = 800000 x 25%= 200000

b. NPV if do not contain oil= -100000 x 75%= -75000

NPV if drill= 200000-75000= 125000

If Sell

NPV = 90000

XYZ should drill for oil. It is more profitable

2. If Probability of land containing oil is 15%

If Drill

a. NPV if contains oil= 800000 x 15%= 120000

b. NPV if do not contain oil = -100000 x 85%= -85000

If sell

NPV= 90000

XYZ should sell the land