I have read the chapter and looked on the Internet for othersources of explanati

ID: 2913515 • Letter: I

Question

I have read the chapter and looked on the Internet for othersources of explanation. I am just not understanding. Ido not understand where to begin on creating a payoff table. Problem: A local energy provider offers a landowner $180,000 for theexploration rights to natural gas on a certain sitea nd the optionfor future development. This option, if exercised is worth anassitional $1,800,000 tot he landowner, bu this will occur only ifnaural gas is discovered during the exploration phase. Thelandowner, believing tht the energy company's interest in the siteis a good indiction tht gas is present, is tempted to develop thefield herself. To do so, she must contract with local experts innatural gas exploration and development. The initial cost for sucha contract is $300,000, which is lost forever if no gas is found onthe site. If gas is discovered, however, the land owner expects toearn a net profit of $6,000,000. Finally the landowner estimatesthe probability of finding gas on the site to be 60%. a. Formulate a payoff table tht specifies thelandowner's payoff (in dollars) associated with each possibledecision and each outcome with respect to finding natural gas onthe site. I have read the chapter and looked on the Internet for othersources of explanation. I am just not understanding. Ido not understand where to begin on creating a payoff table. Problem: A local energy provider offers a landowner $180,000 for theexploration rights to natural gas on a certain sitea nd the optionfor future development. This option, if exercised is worth anassitional $1,800,000 tot he landowner, bu this will occur only ifnaural gas is discovered during the exploration phase. Thelandowner, believing tht the energy company's interest in the siteis a good indiction tht gas is present, is tempted to develop thefield herself. To do so, she must contract with local experts innatural gas exploration and development. The initial cost for sucha contract is $300,000, which is lost forever if no gas is found onthe site. If gas is discovered, however, the land owner expects toearn a net profit of $6,000,000. Finally the landowner estimatesthe probability of finding gas on the site to be 60%. a. Formulate a payoff table tht specifies thelandowner's payoff (in dollars) associated with each possibledecision and each outcome with respect to finding natural gas onthe site.

Explanation / Answer

The thing you need to understand is that the (value of success)* (probability of success) gives you the relative value of thisoption.

As I see it, there are three options:

A) Do nothing.

B) Sell the energy provider the explorationrights: $ 180 K

a. Natural gas is not found: $ 0 K * .4 = 0 K

b. Natural gas is found: $ 180K * .6 = 108 K

Total $ 288K

C) Develop the fieldherself: $ -300 K

a. Natural gas is not found: $ 0 K * .4= 0 K

b. Natural gas is found: $ 6000 K * .6= 36000 K

Total $ 35700K

InitialCost/Profit

No Natural Gas

40 %

Natural Gas

60 %

Outcome

Option A

$ 0

Option B

$ 180 K

$ 0

$ 108 K

$ 288 K

Option C

$ - 300 K

$ 0

$ 36000

$ 35700 K

I hope this helps!