Question

6. A prospective oil field contains either 20M barrels or 5M barrels. Each barrel of oil will generate $0.5 of cashflow in present value. It will cost $4M to drill the well required. a. If either quantity of oil is equally likely, would you proceed with the project

Answer 1

Answer: Expected value = $2,250,000. Proceed with project as this is positive.

Explanation:

Return if oil field contains 20 million barrels:

= (0.5 * 20 million) - 4 million

= 10,000,000 - 4,000,000

= $6,000,000

Return if oil field contains 5 million barrels

= (0.5 * 5 million ) - 4 million

= 2,500,000 - 4,000,000

= -$1,500,000

Both outcomes happening are equally likely so the expected value of this project is:

= (0.5 * 6,000,000) + (0.5 * -1,500,000)

= $2,250,000

Expected value is positive so you should proceed with the project.