The directors understand how a geologist arrived at the probability
estimate. through consideration of the probty of success of each of the 3
main attributes of oil discovery.
Overall Prob = Trap(0.8) x Reservoir(0.8) x Source(0.5) = 0.32
What they don't understand is how to deal with the geologist's comment that a
successful first well would prove the presence of a source, and that this
would alter the ex-post probability estimates of the 2nd prospect as follows:
First Well Outcome Source Prob. Overall Prob.
Success 0.8 0.512
Failure 0.5 0.32
Assist the directors in their determination and indicate:
i) which prospect should be drilled first
ii) whether the 2nd should be drilled if the 1st was a failure.
This is then evaluated using a probability decision tree:
Solution:
Prospect A would be rejected
NPVA = $30m x 0.32 - $10m = -$0.4m
Prospect B would be accepted
NPVB = $40m x 0.32 - $10m = $2.8m
If prospect B was successful, then the probabilities on prospect A would
change, thus its value would be:
NPV = $30m x 0.512 - $10m = $5.36
which would happen with a 0.32 probability, thus the 'expected' value of
prospect B would be: $5.36 x 0.32 = $1.715m
The total value of the 'permit' containing the two prospects is therefore:
$2.8m + $1.715m = $4.515m
However, if these were drilled in the ***reverse order*** , the value would
be $4.858m as follows:
[($40m x 0.512 - $10m) + 30m] x 0.32 + 0.68 x [$40m x 0.32 -$10m]
-$10m = $4.858
Logic says that you would drill the more attractive 'prospect B' first, but
the above suggests otherwise. Where is the flaw?
Cheers
-----------------------------------------------------------------------
"Merde!" Count Cambronne's (General of the Old Guard Chasseurs)
reply to the Allies' offer of surrender at Waterloo. Direct & succinct.
Brad Thompson | Internet: brad_t@csuvax1.murdoch.edu.au
Finance | Tel +61 09 360 6275 Fax +61 09 310 5004
Murdoch University, Perth, West Australia 6150