A landowner in Texas is offered $200,000 for the exploration rights to oil on he
ID: 3209584 • Letter: A
Question
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 70%.
What should the landowner do?
How is this worked out, please? Thank you
She should sell the exploration rights as the EMV of selling is 1.51 million, which is higher than the EMV of developing herself.
She should develop herself as the EMV of developing is 4.5 million, which is higher than the EMV of selling.
She should develop herself as the EMV of developing is 3.75 million, which is higher than the EMV of selling.
There is not enough information to answer this question.
a.She should sell the exploration rights as the EMV of selling is 1.51 million, which is higher than the EMV of developing herself.
b.She should develop herself as the EMV of developing is 4.5 million, which is higher than the EMV of selling.
c.She should develop herself as the EMV of developing is 3.75 million, which is higher than the EMV of selling.
d.There is not enough information to answer this question.
Explanation / Answer
Answer:
Let’s consider different scenarios to determine the Expected Monetary Value:
Case1: Sell the exploration rights
It is given that the probability of finding oil on the site = 70% = 0.7
Therefore the probability that the oil will not be found on the site = 1-0.7 = 0.3
Amount given by the exploration company irrespective of whether the oil is found or not = $200,000
If oil is discovered than Royalty amount = 25% of future profits = 25% * 7500000 = 1875000.
Probability of discovering oil at the site = 0.7
Therefore Expected Monetary value = fixed exploration amount + Probability of finding oil*Royalty amount = $200000 + 0.7*1875000 = $1,512,500 = 1.51 million
Case 2: Develop the well herself:
In this case fixed cost of such well that she has to bear irrespective of whether oil is found or not = $750000
Probability that oil is not found = 0.3
Future profits if oil is found = $7500000
Probability that oil is found = 0.7
Therefore Expected Monetary value = 0.7*7500000 + (-750000) = $4,500,000 = 4.5 million
So based on the comparison of the 2 scenarios, the expected monetary value of Case 2 (develop the well on her own) is more therefore, she should proceed by developing her own well.
So answer is (b) - She should develop herself as the EMV of developing is 4.5 million, which is higher than the EMV of selling.
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