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How To Use Decision Tree To Model A Decision

Question

Simon Lafleur is the founder and sole proprietor of Wetaskawin Wildcatters (WW). WW develops oil wells in unproven territory. Simon has poured his life savings into WW in the hope of finding a major well. WW has purchased drilling rights on a number of tracts that have been spurned by the major oil companies. Simon has just received a report from his consulting geologist that one of these tracts looks modestly promising. The geologist has stated that based on his experience there is a one in four chance of finding a small oil reservoir on the site. Drilling for oil will cost $100,000 and if oil is not found this entire investment will be lost. Since WW has little capital left, this loss could spell doom for the company. If oil is found there it would likely be enough to generate revenues of $800,000. (Ignore time value of money considerations – assume that the $800,000 can be compared directly to the cost of drilling, so that a net gain of $700,000 would be realized if he found oil.) Simon is confident that this amount of money would give him the breathing space required to find the really big “gusher”. Shortly after receiving the report from the geologist, Simon was offered $90,000 for the drilling and extraction rights from one of the major oil companies. This would provide a good infusion of cash without the risk of losing $100,000 if he decides to drill.

a) Use a decision tree to model Simon’s decision (Treeplan software is optional). Assuming that Simon bases his decisions on EMV, what should he do?

b) What is the expected value of perfect information?

 

Summary

The question belongs to Statistics and it discusses about using decision tree to model a decision on EMV and calculation of expected value of perfect information.

Total Word Count 215

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