A local energy provider offers a landowner $180,000 for the exploration rights to natural gas on a certain site and the option for future development. This option, if exercised, is worth an additional $1,800,000 to the landowner, but this will occur only if natural gas is discovered during the exploration phase. The landowner, believing that the energy company's interest in the site is a good indication that gas is present, is tempted to develop the field herself. To do so, she must contract with local experts in natural gas exploration and development. The initial cost for such a contract is $300,000, which is lost forever if no gas is found on the site. If gas is discovered, however, the landowner expects to earn a net profit of $6,000,000. Finally, the landowner estimates the probability of finding gas on this site to be 60%.

Suppose now that, at a cost of $90,000, the landowner can request that a soundings test be performed on the site where natural gas is believed to be present. The company that conducts the soundings concedes that 30% of the time the test will indicate that no gas is present in particular site, the soundings test accurate 90% of the time.

a. Given that the landowner pays for the soundings test and the test indicates that gas is present, what is the landowner's revised estimate of the probability of finding gas in this site?

b. Given that the landowner pays for the soundings test and the test indicates that gas is not present, what is the landowner's revised estimate of the probability of not finding gas in this site?

c. Should the landowner request the given sounding test at a cost of $90,000? Explain why or why not. If not, when (if ever) would be landowner choose to obtain the soundings test?.

Solution Summary

Word document attached estimates the probability of finding gas on several sites.

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