Problem 3 The Newox Company is considering whether or not to drill for natural g

Question

Problem 3
The Newox Company is considering whether or not to drill for natural gas on its own land. If they drill, their initial expenditure will be $40,000 for drilling costs. If they strike gas, they must spend an additional $30,000 to cap the well and provide the necessary hardware and control equipment. (This $30,000 cost is not a decision; it is associated with the event "strike gas.")
If they decide to drill but no gas is found, there are no other subsequent alternatives, so their outcome value is $-40,000. If they drill and find gas, there are two alternatives. Newox could sell to West Gas, which has made a standing offer of $200,000 to purchase all rights to the gas well's production (assuming that Newox has actually found gas).
Alternatively, if gas is found, Newox can decide to keep the well instead of selling to West Gas; in this case Newox manages the gas production and takes its chances by selling the gas on the open market.
At the current price of natural gas, if gas is found it would have a value of $150,000 on the open market. However, there is a possibility that the price of gas will rise to double its current value, in which case a successful well will be worth $300,000.
The company's engineers feel that the chance of finding gas is 30 percent; their staff economist thinks there is a 60 percent chance that the price of gas will double.

Create a decision tree and decide if the company should drill for gas or not.

Explanation / Answer

Lets construct all the possible outcomes and their various probabilities: 1. Dig for gas, do not find anything: probability of occurence = 70%, outcome = -$40,000 2. Dig for gas, strike gas, sell: probability of striking gas = 30%, probability of selling (if gas prices don't double) = 40%, total probability of outcome = 30*40% = 13.33%, outcome = -(40,000 + 30,000) + 200,000 (from sale) = $130,000 3. Dig for gas, strike gas, double value and don't sell: 30% chance of striking gas * 60% chance of doubling value = 20% total probability. Outcome = -(40,000 + 30,000) + 300,000 = $230,000 So whats the expectation value of the whole process of digging for gas? its (70% * -$40,000) + (13.33% * $130,000) + (20% * $230,000) = -$28,000 + $17,332 + $ 46,000 = $35,332 In other words, the expectation value is that on average, if they dig for gas, they will net $35,332, but if they dont dig, they will not earn anything. So on average, they make more if they dig than if they dont, so the smart decision would be to dig. Hope that helps Jonathan

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