Allman Bros. Exploration Company

Allman Bros. Exploration Company is evaluating a drilling project located in a state protected area. The project would require a proper permit, at a cost of $500,000, before any well can be drilled. The Company believes there is a 25 percent chance their permit application would be denied. The Company believes there is a 50 percent chance they would receive an unrestricted permit and a 25 percent chance their permit would be accepted with restrictions.

Pending approval of the permit, the Company must choose whether or not to drill a well. A well will cost $2 million if they receive an unrestricted permit and $3 million if the permit is restricted. The Company believes there is a 70 percent chance of a successful well if drilled and a 30 percent chance of a dry hole. It is believed a successful well will earn a net present value of $9.5 million prior to the consideration of the costs related to the permit and the drilling of the well. The company has been offered $600,000, from a private party, for the mineral rights to this property if it chooses not to drill the well. Alternatively, the State Government will award the Company a total of $400,000 for the mineral rights if the Company applies for a permit and is denied.

Required:

1. Prepare, in good form, a decision tree for this project.

2. What is the expected value of this project?