Reference no: EM1388297

D. Craig Exploration Company has been offered a lease to drill for oil on a particular piece of property. While oil has been found on nearby land, there are no assurances that D. Craig will be successful in finding oil. The company feels that it will strike a major find, an average find, or a dry hole. A major find can be sold to an oil company for $6 million, while an average find will only be sold for $2 million. A dry hole will cost the company $80,000 to cap.

The lease costs $400,000, plus if the oil well is sold to an oil company, then 20% of the revenue goes to the lease. D. Craig estimates that it can drill a well at a cost of $160,000. Without further testing, D. Craig' geologist estimates that there is a 5% chance that the well will be a major find, a 35% chance that it will be an average find, and a 60% chance that it will be a dry hole.

In order to get a better estimate of the probability of finding oil in the well, the geologist is contemplating performing either a geologic or a seismic test. A geologic test will cost $20,000. If the test predicts oil, the geologist believes that the following probabilities hold:
P(test predicts oil | major find) = .70
P(test predicts oil | average find) = .50
P(test predicts oil | dry hole) = .30

Instead of the geologic test, the firm can perform the more detailed seismic test, which costs $50,000. If this test predicts oil, the geologist believes that the following probabilities hold:
P(test predicts oil | major find) = .90
P(test predicts oil | average find) = .70
P(test predicts oil | dry hole) = .10

If D. Craig gets a prediction of oil from either the geologic or seismic tests, it can sell a half-interest in the well to a Dallas investor for $800,000. In this case D. Craig will be responsible for any and all losses on the well should it lose money, but will split profits (excluding cost for conducting tests) on the well equally with the investor if it makes profit.

What is D. Craig' optimal strategy?