Mobile Oil company has recently acquired oil rights to a new potential source
of natural oil in Alaska. The current
market value of these rights is $90,000.
However, if there is natural oil at the site, it is estimated to be
worth $800,000; however, the company would have to pay $100,000 in drilling
costs to extract the oil. The company
believes there is a 0.25 probability that the proposed drilling site actually
would hit the natural oil reserve.
Alternatively, the company can pay $30,000 to first carry out a seismic
survey at the proposed drilling site.
Historically, if the seismic survey produces a favorable result, there
is a 0.50 chance of hitting oil at the drilling site. However, if the seismic survey produces an
unfavorable result, there is only a 0.14285 probability of hitting oil. The probability of an unfavorable seismic
survey when no oil is present is 0.80.
a. What is the
probability of a favorable seismic survey?
b. What is the
probability of an unfavorable seismic survey?
c. Construct a
decision tree for this problem.
d. What is the
optimal decision strategy suing the EMV criterion?
e. To which
financial estimate in the decision tree is the EMV most sensitive?