Oilco must determine whether or not to drill for oil in the South China Sea. If

Question

Oilco must determine whether or not to drill for oil in the South China Sea. If the decision is “not drilling”, the option can be sold for $10 million. If “drilling” is chosen, the well can occur to be dry with probability of 0.5 which would result in a loss of $70 million. The well may be wet with probability of 0.3 and a resultant payoff of $50 million, or may gush out with probability of 0.2 and a resultant payoff of $200 million. Assuming that Oilco is a risk-neutral decision maker, answer the following questions.

Determine EVPI.

Explanation / Answer

There are 2 branches on this decision node:

Now the expected value of taking this this decision would be:

E(Drill ) = -70*0.5 + 50*0.3 + 200*0.2 = -35 + 15 + 40 = $20 million

Therefore the expected monetary values (EMV) for the 2 decisions are:

E(no drilling ) = $10 million

E( drilling ) = $20 million

Now EVPI is the expected value of perfect information: It is the maximum value that we are ready to pay for exact information. EVPI is computed as:

EVPI = EVwPI - EVwoPI

That is expected value with perfect information - Expected value without perfect information.

The EVwoPI that is the Expected value without perfect information is the maximum EMV = $20 million in case of drilling. Therefore EVwoPI = $20 million

Now computing EVwPI: Here we take the maximum payoffs from each scenario, which would be:

Therefore EVwPI = 0.5*10 + 0.3*50 + 0.2*200 = 5 + 15 + 40 = $60 million

Therefore now putting all the computed values to compute the EVPI we get:

EVPI = EVwPI - EVwoPI = 60 - 20 = $40 million

Therefore the value of the expected value for perfect information here is $40 million

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