Question

There is a 40% chance that the amount of oil in a prospective field is 7 million barrels and a 60% chance of 15 million barrels. If the actual amount of oil is 7 million barrels, the present value of the cash flows from drilling will be $2.5 million. If the amount is 15 million barrels, the present value will be $10 million. The cost to drill the well is $5.5 million. Suppose, a test that costs $500,000 can verify the amount of oil under the ground, is it worth paying for the test?

Please enter the full number as your answer. (i.e., 10,000,000 and NOT 10 million)
What is the net present value of not testing? ____.
What is the net present value of testing? ____.
Should the company periorm the test to verify the amount of oil under the ground?
a) Test
b) No Test

Answer 1

Step-by-step explanation:

the expected generated value (in million $) is

0.4×2.5 + 0.6×10 - 5.5 = 1 + 6 - 5.5 = 1.5

if we add testing

0.4×2.5 + 0.6×10 - 5.5 - 0.5 = 1 + 6 - 6 = 1

if the test is performed and it shows 15 million barrels, then the expected value is

1×10 - 5.5 - 0.5 = 10 - 6 = 4

if the test is performed and it does 7 million barrels, then the expected value is

1×2.5 - 5.5 - 0.5 = 2.5 - 6 = -3.5

so, the expected value is then

0.4×-3.5 + 0.6×4 = -1.4 + 2.4 = 1

which confirms the above detailed calculation with testing.

net present value of not testing : $1,500,000

net present value of testing : $1,000,000

given that the potential loss is $3,500,000 when not testing with a relatively high probability of 40% I would recommend to do the testing, if the company has only this one oil field candidate.

if they have multiple similar sites, then I would NOT recommend the test, as the probabilty that all fail is then very low.

Answer 2

The NPV of not testing is $1.5 million, while the NPV of testing is $1 million. Therefore, the company should opt not to perform the test, as the expected profits are higher without bearing the additional cost of testing.

Step-by-step explanation:

When considering whether to pay for the test to verify the amount of oil under the ground, we first need to calculate the expected value of the project without testing. To calculate the net present value (NPV) of not testing, we multiply each outcome by its probability and subtract the drilling cost:

• 0.40 x $2.5 million = $1 million
• 0.60 x $10 million = $6 million
• Expected value of cash flows without testing = $1 million + $6 million = $7 million
• NPV (no test) = Expected value - drilling cost = $7 million - $5.5 million = $1.5 million

Now, let's calculate the NPV of testing, taking into account the cost of the test:

• If oil is 7 million barrels, NPV (test) = $2.5 million - $5.5 million - $0.5 million = -$3.5 million
• If oil is 15 million barrels, NPV (test) = $10 million - $5.5 million - $0.5 million = $4 million
• Expected NPV (test) = (0.40 x -$3.5 million) + (0.60 x $4 million) = -$1.4 million + $2.4 million = $1 million

Based on these calculations, the NPV of not testing is higher than the NPV of testing. Therefore, the company should opt for no test.