Question

The Geo Teknika (GT) Limited owns a tract of land that may contain oil. A consulting geologist has reported to management that he believes there is oil with probability of 0.2. Because of this prospect, another oil company has offered to purchase the land for $120,000. However, GT Limited is considering holding the land in order to drill for oil itself. The cost of drilling is $150,000. If oil is found, the resulting expected revenue will be $1,050,000, so the company’s expected profit (after deducting the cost of drilling) will be $900,000. A loss of $150,000 (the drilling cost) will be incurred if the land is dry (no oil).

Table 1 summarizes these data. Determine the decision of whether to drill or sell based just on these data.

Table1: Prospective profits for the Geo Teknika (GT) Limited.

	Status of Land	Payoff
Alternative		Oil	Dry
Drill for oil		$ 900,000	-$150,000
Sell the land		$ 120,000	$ 120,000
Probability of status		0.2	0.8

Answer 1

Alternative	oil	Dry
Drill for oil	900000	-150000
Sell the land	120000	120000
Probability of status	0.2	0.8

If we sell the land we will get profit of 120000 with probabity 1. The risk is associated with drilling for oil.

Now we will check the difference in profit with risk for drilling instead of selling it.

	oil	Dry
P=profit difference for drilling instead of selling	900000 - 120000 = 780000	-150000-120000 = -270000
probability of status	0.2	0.8

Expection of P = 0.2*780000 - 0.8*270000 = 156000 - 216000 = - 60000 .

Therefore, selling the land is better desicion.