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# csd.docx - Chapter 9 PROBLEM 1(a The first task with this...

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Chapter 9 PROBLEM 1 (a) The first task with this type of complex ENPV question is to identify the different ‘states of the world’ and their associated probabilities. Once this is done, the project’s NPV in each state of the world can be calculated. These “state of the world” NPVs are then each multiplied by their associated probabilities and added together to give the overall expected NPV or ENPV of the project. There are three stages involved with this project. Stage 1 The seismic survey. There is a 50% chance that this will reveal that the geology indicates the possibility of oil. If it does, we proceed to the next stage. But there is also a 50% chance (i.e. 1.0 – 0.50 = 0.50) that the geology indicates that there will be no oil. Under these circumstances, the company goes no further and abandons the project. Stage 2 The exploration wells. If the seismic survey indicates the possibility of oil then the company will proceed to drill exploration wells to see if oil does actually occur. There is a 30% chance that the exploration well will discover oil, in which case we proceed to stage 3. However, there is a 70% chance (i.e. 1.0 – 0.30 = 0.70) that the exploration well will indicate no oil is present. Under the circumstances, the company will go no further and abandon the project. Stage 3 The appraisal wells. If the exploration wells indicate oil then we will proceed to drill appraisal wells to identify just what quantity of oil is there. There is a 60% chance that the oil will be in negligible quantities (what the question refers to as type I). In those circumstances, the project is then obviously abandoned. However, there is a 32% chance that the appraisal wells will indicate the presence of 42 million barrels of oil (type II) and an 8% chance that 2250 million barrels of oil will be indicated (type III). Under each of these last two circumstances the company will then proceed to extract the oil. As a result, there are five possible outcome combinations, or states of the world. State A Seismic survey indicates no oil and the project is abandoned. State B Seismic survey indicates that there may be oil, an exploration well is drilled and finds no oil. The project is then abandoned. State C Seismic survey indicates that there may be oil, an exploration well is drilled and also indicates oil. Therefore an appraisal well is drilled, but a negligible amount of oil is found. The project is abandoned. State D

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This is the same as for State C, except the appraisal well discovers 42 million barrels of oil which the company then extracts. State E Again, the same as for State C, except the appraisal well discovers 2250 million barrels of oil which the company then extracts. The probability of occurrence of each of these five states can be found from the product of the probability of each event in each state.
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