1. A landowner in Texas is offered $200,000 for the exploration rights to oil on
ID: 3047231 • Letter: 1
Question
1. A landowner in Texas is offered $200,000 for the exploration rights to oil on her land, along with a 25% royalty on the future profits if oil is discovered. The landowner is also tempted to develop the field herself, believing that the interest in her land is a good indication that oil is present. In that case, she will have to contract a local drilling company to drill an exploratory well on her own. The cost for such a well is $750,000, which is lost forever if no oil is found. If oil is discovered, however, the landowner expects to earn future profits of $7,500,000. Finally, the landowner estimates (with the help of her geologist friend) the probability of finding oil on this site to be 25%. What should the landowner do? a.She should sell the exploration rights as the EMV of selling is 1.43 million, which is higher than the EMV of developing herself b.She should develop herself as the EMV of developing is 1.125 million, which is higher than the EMV of selling. c. She should develop herself as the EMV of developing is 4.9 million, which is higher than the EMV of selling. d. There is not enough information to answer this question. 1 pointsExplanation / Answer
Probability of finding the oil on the site = 0.25
EMV for selling the exploration rights = Sell Price + Proabability of finding the oil * Royalty% * Future profits
$200,000 + 0.25 * 0.25 * $7,500,000 = $668,750
EMV of developing = Proabability of finding the oil * Future Profits - Cost of Well
= 0.25 * $7,500,000 - $750,000 = $1,125,000 = $1.125 million
As, EMV of developing is greater than EMV for selling the exploration rights, the landowner should develop the site herself.
So, the correct option is,
b. She should develop herself as the EMV of developing is 1.125 million, which is higher than the EMV of selling.
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