Problem:
Your midrange guess as to the amount of oil in a prospective field is 10 million barrels, but in fact there is a 50 percent chance that the amount of oil is 15 million barrels, and a 50 percent chance of 5 million barrels.
If the actual amount of oil is 15 million barrels, the present value of the cash flows will be only $2 million. It costs $3 million to drill the well. Suppose that a seismic test that costs $100,000 can verify the amount of oil under the ground. Is it worth paying for the test?
Small Large
Barrels of Oil 5,000,000 15,000,000
PV of cash flows $2,000,000 $8,000,000
Cost to drill well $3,000,000
Seismic test cost $100,000
Expected NPV without testing FORMULA
Expected NPV with testing FORMULA