- 20 Marks
Question
An oil company has recently acquired rights in a certain area to conduct surveys and test drillings for oil where it is found in commercially exploitable quantities.
The area is already considered to have good potential for finding oil in commercial quantities. At the outset the company has the choice to conduct further geological tests or to carry out a drilling programme immediately. On the known conditions, the company estimates that there is a 70:30 chance of further tests showing a „success‟.
Whether the tests show the possibility of ultimate success or not, or even if no tests are undertaken at all, the company could still pursue its drilling programme, or alternatively consider selling its rights to drill in the area. Thereafter, however, if it carries out the drilling programme, the likelihood of final success or failure is considered dependent on the foregoing.
If „successful‟ tests have been carried out, the expectation of success in drilling is given as 80:20;
If the tests indicate „failure‟, then the expectation of success in drilling is given as 20:80;
If no tests have been carried out at all the expectation of success in drilling is given as 55:45.
Costs and revenues have been estimated for all possible outcomes and the net present value of each is given below:
| Outcome | Net present value N’m |
|---|---|
| Success: | |
| With prior tests | 100 |
| Without prior tests | 120 |
| Failure: | |
| With prior tests | -50 |
| Without prior tests | -40 |
| Sales of exploitation rights: | |
| Prior tests show „success‟ | 65 |
| Prior tests show „failure‟ | 15 |
| Without prior tests | 45 |
You are required to:
a. Draw up a decision (probability) tree diagram to represent the above information. (10 Marks)
b. Evaluate the tree in order to advise the management of the company on its best course of action. (7 Marks)
c. Discuss the value of decision trees in providing management with guidance for decision making. Give examples of any situations where you consider their use would be of benefit. (3 Marks)
Answer
[Image of decision tree]
b) The EV at point F is 0.8 ×100 80
- 0.2 × (50) (10) 70_
The decision at point D will be to pursue the programme rather than sell the rights, and the EV at point D is therefore 70.
The EV at point G is 0.2 ×100 20
- 0.8 × (50) (40) 20_
The decision at point E will be to sell the rights rather than pursue the programme, and the EV at point E is 15.
The EV at point C is 0.55 × 120 66 +0.45 × (40) (18) 48
The EV at point B is 0.7 × 70 49
- 0.3 × 15 4.5 53.5
The decision at point A is between a) Conducting tests EV N53.5 million b) Not conducting tests and pursuing the programme – EV N48 million c) Not conducting tests and selling the rights – EV N45 million
The EV at point A, choosing option (a) with the highest EV, is N53.5 million.
c) Decision trees are useful in giving a simple diagrammatic representation of the various decision options open to management, and the possible outcomes of each decision. They also draw attention to the immediate decision to be made, and may help management to avoid wasting unnecessary time deliberating „second stage‟ decision (such as at points D and E in (a)) which cannot yet be made.
A decision tree might also help management to eliminate decision options which are not worthwhile to consider further, and to focus attention on the more viable options.
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