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There is a 38% chance that the amount of oil in a prospective field is 7 million barrels and a 62% chance of 14 million barrels
There is a 38% chance that the amount of oil in a prospective field is 7 million barrels and a 62% chance of 14 million barrels. If the actual amount of oil is 7 million barrels, the present value of the cash flows from drilling will be $3.5 million. If the amount is 14 million barrels, the present value will be $10 million. The cost to drill the well is $4.5 million. Suppose, a test that costs $125,000 can verify the amount of oil under the ground, is it worth paying for the test?
Please enter the full number as your answer. (i.e., 10,000,000 and NOT 10 million)
What is the net present value of not testing?
What is the net present value of testing?
Should the company perform the test to verify the amount of oil under the ground?
No Test or Test
Expert Solution
Present Value of not Testing
NPV, if actual amount of oil is 7 million barrels = $3.5 million -$4.5 million = $-1.0 milliion
NPV, if actual amount of oil is 13 million barrels = $10 million -$4.5 million = $5.5 milliion
PV of not Testing = -1 * 38% + 5.5 * 62%
PV of not Testing = $3.03 million i.e. $3,030,000
Present Value of Testing
NPV, if actual amount of oil is 7 million barrels = $0 (abandon)
NPV, if actual amount of oil is 13 million barrels = $10 million -$4.5 million = $5.5 milliion
PV of Testing = (-0 * 38% + 5.5 * 62% ) - Cost of Testing
PV of testing = $3.41 - 0.125
PV of testing = $3.285 million i.e.$ $3,285,000
Present value of testing is higher, thus company should perform the test.
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