You are considering buying an oil field. If you buy the field, you can extract t

Question

You are considering buying an oil field. If you buy the field, you can extract the oil in one year. There are 100 barrels of oil that can be extracted from the field; the cost of doing so is $4,000. You expect the price of oil in one year to be $50/barrel. However, there are four equally likely prices of oil in one year: $20/barrel, $35/barrel, $40/barrel, and $105/barrel.  

Of the below prices, what is the minimum price at which you would drill in year 1, if you buy the field today?   Assume the price of oil never changes after one year.

A. $35/barrel

b. $20/barrel

c. $41/barrel

d. $105/barrel

Explanation / Answer

The correct answer is C. $ 41 / barrel

Explanation:- The total cost of extracting 100 barrels of oil is $ 4000 and there are no other costs involved. Thus the minimum price at which you will drill in year 1 is the price which covers the total cost and leaves you with a little profit . At a price of $ 20, you would get $ 2000 ($20 x 100 barrels) so that leaves you with a loss. At a price of $ 35, you would get $ 3500 ( $ 35 x 100) and again you face loss. At a price of $ 41 , you would get $ 4100 ( $ 41 x 100) and you will make a slight profit of $ 100 ( $ 4100 - $ 400) . Thus $ 41 is the minimum price you will drill the oil.

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