Question

Max Flyer is the founder and sole owner of the Go for broke Company. The company develops oil wells in unproven territories. His company has purchased a tract of land that larger oil companies have spurned as unpromising even though it is near some large oil fields. Max has provided you the following information:

• Drilling for oil on the tract would cost $100,000 (his investment). If the drilling is successful, and the well produces oil, his revenue would be $800,000. If the well turns out to be a dry hole he loses the entire $100,000. The chance of hitting oil on the tract of land is 1 in 4, or 25%.

• Max does have the option of selling the tract of land. Another oil company, after hearing a geologist’s report, would like to purchase the land for an amount that would provide him a profit of $90,000.

• A friend of Max has told him about a company that does seismic studies. The cost of a study is $30,000. If the study is performed there is a 70% chance that the results will be unfavorable. If the study results are unfavorable, and Max decides to drill for oil anyway, there is an 85.7% chance that he will have a dry well. If the results are favorable, and Max decides to drill, there is a 50% chance that he will have a dry well.

• These are the only alternatives Mr. Flyer has. The alternatives are mutually exclusive.

You have been asked to help Mr. Flyer.  Since you are familiar with how to use decision trees to solve problems, prepare a report that will help Mr. Flyer make his decision in this situation.  Your report should be addressed to Mr. Flyer.

Answer 1

Decision tree is made use of for deciding average profit on each action. Figures in bracket indicate probabilities. The combined probability for any action is obtained by multiplying each probabilities in that path. For example, under favourable study , hitting of oil has probability .3x.5.