Use expected value calculation method to evaluate the following business proposi

Question

Use expected value calculation method to evaluate the following business proposition

A Texas oil drilling company has determined that it costs $25,000 to sink a test well. If oil is hit, the net revenue for the company will be $475,000 (which is $500,000 gross revenue - $25,000 drilling cost). If natural gas is found, the net revenue will be $125,000 (which is $150,000 gross revenue - $25,000 drilling cost). If the probability of hitting oil is 3.00% and of hitting gas is 6.00%, find the expected value of sinking a test well.

Explanation / Answer

The expected value is RevenueA * P() + Revenue B * P(B) - Cost * [1-P(A)-P(B)]

Revenue A = 475000, P(A) = 3% = 0.03

Revenue B = 125000, P(B) = 6% = 0.06

Cost of Drilling = 25000, P(Not finding anything) = 1-0.3-0.6 = 0.91

Therefore Expected Value = 475000 * 0.03 + 125000 * 0.06 - 25000 * 0.91 = 14250 + 7500 - 22750 = -1000

Every time they sink a test well there is an expected loss of 1000.

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