. A local energy provider offers a landowner $180,000 for the exploration rights

Question

. A local energy provider offers a landowner $180,000
for the exploration rights to natural gas on a certain
site and the option for future development. This
option, if exercised, is worth an additional $1,800,000
to the landowner, but this will occur only if natural gas
is discovered during the exploration phase. The
landowner, believing that the energy company’s interest
in the site is a good indication that gas is present, is
tempted to develop the field herself. To do so, she
must contract with local experts in natural gas exploration
and development. The initial cost for such a
contract is $300,000, which is lost forever if no gas is
found on the site. If gas is discovered, however, the
landowner expects to earn a net profit of $6,000,000.
Finally, the landowner estimates the probability of
finding gas on this site to be 60%.

Explanation / Answer

Well. if you are trying to figure the expected value, it is [(180,000) +(300,000) ]*.4 +[ (180,000)+(300,000)+ (1,800,000)+6,000,000]* .6 (192,000) + 2,232,000= 2,040,000. Assuming the provider isn't totally risk averse, it seems like a good deal.

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