Question

There is a 38% chance that the amount of oil in a prospoctive field is 6 million barrels and a 62% chance of 13 million barreis. If the actual amount of oil is 6 million barrels, the present value of the cash flows from drlling will be $1million. If the amount is 13 million barrels, the present value will be $7 million. The cost to drili the well is $5.5 million. Suppose, a test that costs $100,000 can verily the amount of oil under the ground, is it worth paying for the fest? Piease enter the full number as your answer. (i.e., 10,000,000 and NOT 10 milion) What is the net present value of not testing? What is the net present value of testing? Should the company pertorm the test to verity the amount of oll under the ground?

Answer 1

The net present value of not testing is -$4.5 million and the net present value of testing is $1.5 million. The company should perform the test to verify the amount of oil under the ground.

Step-by-step explanation:

To determine whether it is worth paying for the test, we need to find the net present value (NPV) of testing and not testing.

If the company performs the test, the present value of cash flows from drilling will be $7 million (62% chance of 13 million barrels). Subtracting the $5.5 million drilling cost, the NPV of testing is $1.5 million.

If the company does not perform the test, the present value of cash flows will be $1 million (38% chance of 6 million barrels). Subtracting the $5.5 million drilling cost, the NPV of not testing is -$4.5 million.

Therefore, the net present value of not testing is -$4.5 million and the net present value of testing is $1.5 million. Since the NPV of testing is positive, the company should perform the test to verify the amount of oil under the ground.