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Southern Gas Company (SGC) is preparing to make a bid for oil and gas leasing rights in a newly opened drilling area in the Gulf of Mexico. SGC is trying to decide whether to place a high bid of $16 million or a low bid of $7 million. SGC expects to be bidding against its major competitor, Northern Gas Company (NGC) and predicts NGC to place a bid of $10 million with probability 0.4 or a bid of $6 million with probability 0.6. Geological data collected at the drilling site indicates a 0.15 probability of the reserves at the site being large, a 0.35 probability of being average, and a 0.50 probability of being unusable. A large or average reserve would most likely represent a net asset value of $120 million or $28 million, respectively, after all drilling and extraction costs are paid. The company that wins the bid will drill an exploration well at the site for a cost of $5 million.
a. Develop a decision tree for this problem.
b. What is the optimal decision according to the EMV criterion?
c. Create a strategy table showing how the optimal decision would change if the probability of the NGC bidding $10 million varies from 0% to 100% in steps of 10%.
d. Create a strategy table showing how the optimal decision would change if the net asset value of a large reserve varies from $100 million to $140 million in $5 million increments and the net asset value of an average reserve varies from $20 million to $36 million in increments of $2 million.
The procedure to make the decision tree in Excel is written below:
1. Install the Risk Solver Platform.
2. Click the Risk Solver Platform tab.
3. Click Decision Tree, Node, Add Node.
4. Enter the Nodes as SGC Bids 16 and SGC Bids 7 with values 0 for both.
5. Select the terminal node for the branch labeled SGC Bids 16.
6. Click Decision Tree, Node, Change Node. This time select the Event option.
7. Enter the Nodes as NGC Bids 10 and NGC Bids 6 with values -21 for both and chances as 0.4 and 0.6 respectively.
8. Select this node. Click on the Decision Tree, Node, Copy Node.
9. Select the target cell(F45). Click on Decision Tree, Node, Paste Node.
10. Enter the Nodes as NGC Bids 10 and NGC Bids 6 with values 0 and -12 and chances as 0.4 and 0.6 respectively.
11. Click Decision Tree, Node, Change Node. Again select the Event option.
12. Enter the Nodes as Large, Avg, Unusable with values 120, 28, 0 and chances as 0.15, 0.35 and 0.5 respectively at cell J8.
13. Select this node. Click on the Decision Tree, Node, Copy Node.
14. Select the target cell(J23). Click on Decision Tree, Node, Paste Node.
15. Click Decision Tree, Node, Change Node. Again select the Event option.
16. Enter the Nodes as Large, Avg, Unusable with values 0, 0, 0 and chances as 0.15, 0.35 and 0.5 respectively.
17. Select this node. Click on the Decision Tree, Node, Copy Node.
18. Select the target cell(J38). Click on Decision Tree, Node, Paste Node.
19. Click Decision Tree, Node, Change Node. Again select the Event option.
20. Enter the Nodes as Large, Avg, Unusable with values 120, 28, 0 and chances as 0.15, 0.35 and 0.5 respectively.
21. Select this node. Click on the Decision Tree, Node, Copy Node.
22. Select the target cell(J53). Click on Decision Tree, Node, Paste Node.
Where are they getting -21 for NGC Bids 10 and NGC bids 6?
Where are they getting the values 0 and -12 for NGC Bids 10 and NGC bids 6?
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