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What is the optimal policy for the firm

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Question - DrillTech Ltd (DTL), a natural resources company has the opportunity to convert to explore for a mineral concession. Suppose that the firm has two choices in period 0, namely to (1) proceed and explore or (2) abandon. Abandoning the project carries zero costs. However, should decide to go ahead and explore, there is an 80% chance (probability) of no discovery, and the remainder is the probability of discovery. If they decide to appraise the discovery after discovery, then there is a 20% chance of finding a large mine worth $500 million, 35% chance of a medium mine worth $350 million and another 45% chance of a small mine worth $250 million. The cost of exploration and appraisal are $50 million and $30 million respectively.

Suppose that the firm is risk-neutral and wishes to maximize the expected present value obtained by the firm.

1. Draw a decision tree representing the decision problem facing the firm.

2. What is the optimal policy for the firm to follow regarding the decision to explore? Explain your answer.

Reference no: EM133176093

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