A local energy provider offers a landowner $180,000 for the exploration rights to natural gas on
a certain site and the option for future development. This option, if exercised, is worth an
additional $1,800,000 to the landowner, but this will occur only if natural gas is discovered
during the exploration phase. The landowner, believing that the energy company’s interest in the
site is a good indication that gas is present, is tempted to develop the field herself.
To do so, she must contract with local experts in natural gas exploration and development.
The initial cost for such a contract is $300,000, which is lost forever if no gas is found on the site.
If gas is discovered, however, the landowner expects to earn a net profit of $6,000,000.
The landowner estimates the probability of finding gas on this site to be 60%.
a. Create a payoff table that specifies the landowner’s payoff (in dollars) associated with each
possible decision and each outcome with respect to finding natural gas on the site.
Decision Outcome EMV
Gas is discovered Gas is not discovered
Sell exploration rights
Develop the field herself
b. What is the strategy that maximizes the landowner’s expected net earnings from this opportunity?
What is the expected payoff associated with this decision?
c. Draw by hand a decision tree. Make sure to label all decision and chance nodes and include
appropriate costs, payoffs and probabilities.
d. Suppose the landowner could request a perfectly reliable soundings test on the site where
natural gas is believed to be present. What is the most the landowner should be willing to pay
for this test?
e. Use the file LandownerGasExploration_39.xlsx and PrecisionTree add-in to create a
decision tree with Excel and perform a sensitivity analysis on the optimal decision,
letting each of the five inputs vary one at a time plus or minus 25% from its base value.
Submit your Excel file on Blackboard.
f. Summarize your findings in the hard copy of the homework that you are turning in.
g. In response to which model inputs is the expected profit value most sensitive?
What chart(s) did you use to make your conclusion?
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