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Decision tree

1. The table below summarizes the payoffs you can expect to receive from investing in a limited partnership owning interests in an oil field. If the field is leased, you will receive the base lease amount plus royalties on any oil discoveries. If the field is drilled for oil, you will receive your share of the oil value. If no oil is discovered, you will have to cover the expenses of drilling. The payoffs are to you and they are in thousands of dollars.

The Discovery
Action Hit Oil No Oil
Drill $80 -$30
Lease $20 $10
Probability: .3 .7
(Payoffs in thousands of dollars)

a. If you are an expected-return maximizer, what action would you prefer? Show why.
b. If your basis for preferring an action is to minimize risk, which action would you prefer? Why?
c. Draw a picture of this decision tree, including the payoffs and probabilities.
d. Suppose that you could know if there is oil or not BEFORE you chose an action (drill or lease), but you don't have that information yet. Draw the tree diagram to represent this situation where you will learn the status of the land first and then decide to invest.
e. Does this new situation have a different expected value than the one evaluated in part (b) above? If so, what is the (dollar) difference? Which situation do you prefer?

See attached file for full problem description.


Solution Summary

The solution explains the scenarion with a well drawn decision tree. The solution also answers all the other questions below.