An oil production company is considering the opportunity to drill for oil. The company needs to purchase an exploration lease for $ 5 million for a certain concession area from the authorities that will give it the right to drill. The drilling program will take five months and cost $5 million. The chances of finding oil are summarized in the table below:
If oil is discovered, the company can sell the oil field or develop it itself. If the company develops the oil field there are two possible outcomes. In the case of a small field, these outcomes are that the oil production facility has a value of $ 60 million if the oil price is high, or $10 million if it is low. If the oil field is large, the value of the production facility is $120 million if the price is high and $ 80 million if it is low. If the company sells the oil field without developing it, it will receive a price that is 12% of the expected value of the production facility. There is an equal probability that prices are high or low.
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- Draw the decision tree for this situation.
- Determine the optimal choice.