A landowner in Texas is offered $250,000 for the exploration
rights to oil on her land, along with a 30% royalty on the future
profits if oil is discovered. The landowner is also tempted to
develop the field herself, believing that the interest in her land
is a good indication that oil is present. In that case, she will
have to contract a local drilling company to drill an exploratory
well on her own. The cost for such a well is $1,000,000, which is
lost forever if no oil is found. If oil is discovered, however, the
landowner expects to earn future profits of $7,500,000. Finally,
the landowner estimates (with the help of her geologist friend) the
probability of finding oil on this site to be 25%.
What should the landowner do?
a.
She should develop herself as the EMV of developing herself is
875,000, which is higher than the EMV of selling.
b.
She should sell as the EMV of selling is 912,500, which is
higher than the EMV of developing herself.
c.
She is indifferent between the two alternatives.
d.
She should sell as the EMV of developing is less than the cost
of $1,000,000.