Answer to Question #66078 in Financial Math for Mage

Question

Watt Lovell Ltd. (WLL) is trying to decide whether or not to drill for oil on a particular site in North Eastern Kenya. The Chief Engineer has assessed the probabilities that there will be oil as follow, based on past experience.Oil 0.2, No oil 0.8
It is possible for WLL to hire a firm of international consultants to carry out a complete survey of the site. WLL has used the firm many times before and has made the following estimates:
1. If there really is oil, then there is a 95% chance that the report will be favourable.
2. If there is no oil then there is only a 10% chance that the report will indicate that there is oil.
The following additional information is also provided:
· The cost of drilling is Sh.10 million.
· The value of the benefits if oil is found is Sh.70 million
· The cost of obtaining information is Sh.3 million.
a) Advise the company on whether to acquire additional information from the consultants
b) Compute the value of imperfect information. (2 marks)

Answer 1

a) The company should acquire additional information from the consultants to be sure about the existance of oil.
b) The forecast is usually correct, but can be incorrect. Imperfect information is not as valuable as perfect information. The value of information (either perfect or imperfect) may be calculated as follows:
Expected Profit (Outcome) with the information LESS Expected Profit (Outcome) without the information =
= 0.8*0.95*(70 - 10 - 3) - 0.8*(70 - 10) = -4.68 million.