Question

Suny Ltd. is a gas provider in Chicago. Mrs. Larry is a landowner of a site that the company is interested to explore. Suny Ltd. offers Mrs. Larry a deal of $200,000 for the exploration rights to natural gas on the site and the option for future development. If natural gas is discovered on the site and Suny Ltd. wishes to develop the site further, then Mrs. Larry will be paid an additional $1,900,000. Mrs. Larry believes that Suny Ltd.’s interest in the site gives rise to the chance that gas is present. So, Mrs. Larry may opt to develop the field independently. Mrs. Larry may sign a contract with Drillers & Co – an expert in natural gas exploration and development, which will cost $250,000 regardless of whether gas is found on the site or not. If gas was discovered, however, Mrs. Larry may earn a net profit of $6,000,000 from the site. Mrs. Larry believes that the probability of finding gas on the site is 65%.

1. Construct a decision tree to describe the decision situation of Mrs Larry. Explain the logic of the tree with the right notations.

2. Define and describe the monetary outcomes in the decision tree.
3. Solve the decision tree to identify the strategy that maximizes Mrs. Larry’s expected net earnings.

4. Develop at least 5 alternative scenarios by varying each of the inputs one at a time within the range of plus or minus 20% from their base values.

5. Repeat steps b) and c) for each of the scenarios in d)
6. Summarize your findings from d) and discuss which of the inputs appears to have the largest effect on the best solution.

Answer 1

a)

P1 = Probability of Not Finiding Gas = 0.35

P2 = Probability of Finding Gas = 0.65

b) Monetary Outcomes in the deciosn Tree is defined as the Expected Profit/Loss that will be generated using a particular option.

Option 1- Net Profit = $200,000; P1 = 0.35

Expected Net Profit Using Option1 = $70,000

Option 2 - Net Profit = $200,000+$1,900,000= $2,100,000; P2=0.65

Expected Net Profits using Option 2 = $13,65,000

Option 3 - Net Loss = $250,000; P1=0.35

Expected Net Loss using Option 3 = $87,500

Option 4- Net Profit = (-$250,000 +6,000,000) = $5,750,000; P1=0.65

Expected Net Profit using Option 4 = $37,37,500

c) Explanation of the earnings to maximize Mr. Does Net Profit-

1. The Total Expected ,rofit Generated from the decison of choosing Electra Ltd. and giving them exploration rights is

= [(P1*$200,000)+(P2*$2,100,000)]

= [(0.35*200,000)+(0.65*2,100,000)]

= $14,35,000

2. The Total Expected Profit Genearted from the decision of choosing Expert & Co. and opting the field independently is

= [(P1*Loss$250,000) +(P2*Net Profit$5,750,000)]

= [{0.35*(-250,000)}]+[{0.65*(-250,000+6,000,000)}]

= $3,650,000