ASSIGNMENT # $3$

Decision Analysis and Project Management

Assignment must be typed $($i$.$e$.$ can NOT be

handwritten$),$ neat, readable, and well$-$organized. However, it is ok to plot GRAPHS by hand and to

SCAN$/$INCLUDE them within the PDF document file if they are large, legible, and properly labeled

and that their calculations are typed within the rest of the assignment. Plotting

using Excel, a paint tool or hand plotting is OK$.$

Submitted assignment solutions $($if applicable$)$ must include $$managerial statements$$ that

communicate the results of the analyses in plain language.

Problem $1(35$ points$)$

Petro Enterprises is a small oil exploration business. They have a nontransferable short$-$term option to

drill on a certain plot of land. Two recent dry holes have depleted Petro's net liquid assets to $$130,000.$

The president must decide whether Petro should exercise its short$-$term option or allow it to expire. $($It

will expire in two weeks if drilling is not commenced by then.$)$ The president has the opportunity of

paying for a seismic test run in the next few days, which could help determine if it is worth drilling.

To conserve capital and maintain flexibility, Petro subcontracts all drilling and seismic tests. It can

have the seismic test performed on short notice at overtime rates for a fixed fee of $$30,000$ and the well

can be drilled for a fixed fee of $$100,000.$ If oil is found, Petro must decide whether to develop the oil

field itself or sell the rights. A large oil company has agreed that if Petro drills and discovers oil, it will

purchase all Petro's rights for $$400,000.$

The company's geologist has examined the geology of the region and states that there is a $0\mathrm{.}55$

probability that if a well is sunk, oil will be discovered. Data on the reliability of the seismic test

indicate that if the test is favourable, the probability of finding oil will increase to $0\mathrm{.}85$ but that if the

test is unfavourable, it will fall to $0\mathrm{.}1.$ The geologist has computed that there is a $0\mathrm{.}6$ probability that

the result will be favourable if the test is made.

Unfortunately, if oil is discovered, it is not possible to know the extent of the find before the decision

as to whether to sell the rights to the land expires. Experience suggests that if oil is found, there is a

$0\mathrm{.}2$ probability that it is a small reservoir, $0\mathrm{.}7$ probability that it is a medium reservoir and $0\mathrm{.}1$

probability that it is a large reservoir. Petro estimates its profits $($not including costs associated with

exploration$)$ from developing the oil field itself to be $$200,000$ if the reservoir discovered is a small

one, $$350,000$ if it is a medium reservoir and $$800,000$ if it is a large one.

Using a Decision Tree, determine Petro's best policy in terms of whether to take advantage of the

seismic test and whether to develop or sell the rights if oil is found. Present your answer in a format of

a Report to Management $($i$.$e$.,$ Verbally communicate the decision strategy$).$