The Newox Company is considering whether or not to drill for natural gas on its own land. If they drill, their initial expenditure will be $40,000 for drilling costs. If they strike gas, they must spend an additional $30,000 to cap the well and provide the necessary hardware and control equipment. (This $30,000 cost is not a decision; it is associated with the event "strike gas.")
If they decide to drill but no gas is found, there are no other subsequent alternatives, so their outcome value is -$40,000. If they drill and find gas, there are two alternatives. Newox could sell to West Gas, which has made a standing offer of $200,000 to purchase all rights to the gas well's production (assuming that Newox has actually found gas).
Alternatively, if gas is found, Newox can decide to keep the well instead of selling to West Gas; in this case Newox manages the gas production and takes its chances by selling the gas on the open market.
At the current price of natural gas, if gas is found it would have a value of $150,000 on the open market. However, there is a possibility that the price of gas will rise to double its current value, in which case a successful well will be worth $300,000.
The company's engineers feel that the chance of finding gas is 30 percent; their staff economist thinks there is a 60 percent chance that the price of gas will double.
To evaluate whether the Newox Company should drill for natural gas on its own land, we need to consider the potential costs and benefits associated with drilling and the probability of different outcomes.
1. Initial Expenditure: The company would need to spend $40,000 for drilling costs, regardless of whether or not they find gas.
2. Outcome if No Gas is Found: If they drill and no gas is found, there are no other subsequent alternatives, and the outcome value would be -$40,000.
3. Outcome if Gas is Found:
a) Selling to West Gas: If they decide to sell to West Gas, they would receive $200,000. This option has a probability associated with it based on the chance of finding gas.
b) Keeping the Well: If they decide to keep the well, they can sell the gas on the open market. The value of the gas depends on the current price and the probability of the price doubling.
Now, let's calculate the expected value of each option using the given probabilities:
Probability of finding gas: 30%
Probability of price doubling: 60%
Expected Value of Selling to West Gas:
EV_selling = Probability of finding gas * Value of selling to West Gas
= 0.30 * $200,000
= $60,000
Expected Value of Keeping the Well:
EV_keeping = Probability of finding gas * [(1 - Probability of price doubling) * Value on current market + Probability of price doubling * Value if price doubles]
= 0.30 * [(1 - 0.60) * $150,000 + 0.60 * $300,000]
= 0.30 * [$60,000 + $180,000]
= 0.30 * $240,000
= $72,000
Based on the expected values, the company should consider drilling for gas because the expected value of the options is positive.
Decision: Drill for natural gas.
Please note that this analysis assumes that all other factors are constant and do not significantly impact the decision. It is always advisable for the company to do a comprehensive evaluation considering all relevant factors and consulting with experts in the field to make an informed decision.