The Mobile Oil company has recently acquired oil rights to a new potential source of natural oil in Alaska. The current market value of these rights is $90,000 (Company can sell the project for $90,000). If there is natural oil at the site, it is estimated to be worth $800,000; however, the company would have to pay $100,000 in drilling costs to extract the oil. The company believes there is a 0.25 probability that the proposed drilling site actually would hit the natural oil reserve. Alternatively, the company can pay $30,000 to first carry out a seismic survey at the proposed drilling site. The probability of a favorable seismic survey is 60% and unfavorable seismic survey is 40%.
If company under seismic favorable result decides to drill, probability of the hit oil is 80% and dry hole is 20%. But if seismic report is unfavorable, probability of hit oil is 10% and dry hole is 90 %. If seismic report came unfavorable, selling value of the project will drop from $90,000 to $50,000. If seismic report came favorable, selling value of the project will increase from $90,000 to $110,000.
a. Construct a decision tree for this problem.
b. What is the optimal decision strategy using the EMV criterion? Highlight all the branches for optimal solution.
The decision tree refers to the flow chart where each node will be representing the test, and branches represent the outcome of the test. This model helps the manager in making the decision, which helps in deciding the net gain from the decision.
Answer and Explanation:
1) Sell right at current market value = $90000
2) Carry out drilling = 0.25*800,000
= $ 200,000
Net Gain =...
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fromChapter 2 / Lesson 12
Clearly identifying all possible solutions for a given decision is an important part of successful management. In this lesson, you will learn how to use a decision tree to identify and select possible courses of action.