Digger Exploration, Inc. is considering an investment in a project that is expected to have a five-year life.. The investment would require the Company to drill a well at a cost of $2.5 million. Digger's hurdle rate is 18 percent. The expected outcomes as a result of the drilling are: High volume: 70% probability - could produce up to 950,000MMBtus each year for five years Medium volume: 20% probability - could produce up to 650,000MMBtus each year for five years Dry hole: 10% probabilty If the well is succssful, the Company would have to make a decision as to whether to build a small or large processing plant. A large processing plant would cost $2,000,000 to construct and could process up to 900,000 MMBtus each year for five years. A small processing plant would cost $1,000,000 to construct and could process up to 600,000 MMBtus each year for five years. The amount of gas that can be sold is also dependent on the favorability of the market. If the well proves to be good, the Company could sell up to 910,000 MMBtus each year for five years whereas a poor market will limit the Company's sales to an estimated 625,000 MMBtus each year for five years. The probabilities of the market type are as follows: High volume (Good Market): 60% Medium volume (Poor Market): 40% Finally, the price received is also dependent on the favorability of the market. The Company believes it will receive $2.60 per MMBtu in a good market but only $2.20 per MMBtu in a poor market. Required: 1. Calculate the NPVs for Options 1,2,3, & 4. 2. Construct a decision tree, in good form, that lists the 10 possible outcomes. 3. What is your recommendation (i.e. should the Company drill the well? If so, what size of a processing plant do you recommend)? What is the expected value of your recommendation?

center Text B fx A B D E F G H Digger Exploration, Inc. is considering an investment in a project thatis expected to have a five-year life. The investment would require the Company to drill a well at a cost of $2.5 million. Digger's hurdle rate is 18 percent. The expected outcomes as a result of the drilling are: High volume: 70% probability-could produce up to 950,000MMBtus each year for five years Medium volume: 20% probability-could produce up to 650,000MMBtus each year for five years Dry hole: 10% probabilty If the well is sucessful, the Company would have to make decision as to whether to build a small or large processing plant. Alarge processing plant would cost $2,000,000 to construct and could process up to 900,000 MMBtus each year for five years. Asmall processing plant would cost $1,000,000 to construct and could process up to 600,000 MMBtus each year for five years. The amount of gas that can be sold is also dependent on the favorability of the market. If the well proves to be good, the Company could sell up to 910,000 MMBtus each year for five years whereas a poor market will limit the Company's sales to an estimated 625,000 MMBtus each year for five years. The probabilities of the market type are as follows: High volume (Good Market): 60% Medium volume (Poor Market): 40% Finally, the price received is also dependent on the favorability of the market. The Company believes it will receive $2.50 per MMBtu in a good market but only $2.20 per MMBtu in a poor market. Required: 1. Calculate the NPVs for Options 1,2,3,& 4. 2. Construct a decision tree, in good form, that lists the 10 possible outcomes. 3. What is your recommendation fi.e. should the Company drill the well? Ifso, what size of a processing plant do you recommend? What is the expected value of your recommendation? Data Financial Factors Table Item Amount Probability Rate Period FV of $1 FVOA of $1 PV of $1 PVOA of Si Capital costs: 18.00% 0 1.000000 1.000000 Drill well S 2,500,000 1 1.180000 1.000000 0.847455 0.847458 Build large processing plants 1.392400 2,000,000 1565642 2. 180000 0.715164 3 1.643032 3.572400 0.608631 2.174273 Build small processing plan $ 1,000,000 1938778 4 5.215432 0515769 2.690062 ste D Copy Format Data 8 8 ' BI U DAO Review View Tools Painter Merge and Wrap Center Text Number *- % de 19 fx Condition Formattin B D E F Amount A Data Item Capital costs: Drill well $ Build large processing plants Build small processing plans Probability M Period Rate 18.00% PVOA of Si 2,500,000 2,000,000 1,000,000 0 1 2 3 4 G H Financial Factors Table FV of $1 FVOA of $1 1.000000 1.180000 1.000000 1.392400 2.180000 1.643032 3.572400 1.938778 5.215432 2.287758 7.154210 PV of S1 1.000000 0.847458 0.718184 0.608631 0.515789 0.437109 0.847458 1565642 2.174273 2.690062 3.127171 5 Volumes that can be produced: High Medium Dry hole 950,000 650,000 0 70% 40% 10% Result Volumes that can be processed: Large plant Small plant 900,000 600,000 Volumes that can be sold in a: Good market Poor market Summary Volume? Plant? High Large High Large High Small High Small Medium Large Medium Large Medium Small Medium Small Dry hole NA NA NA 910,000 625,000 Option Drill? 1 Yes 2 Yes 3 Yes 4 Yes 5 Yes 1. 6 Yes 7 Yes 8 Yes 9 Yes 10 No 6096 4096 Market? Good Poor Good Poor Good Poor Good Poor NA NA 784,919 (200,140) 1,378,387 627,866 (2,500,000) Unit prices in a: Good market Poor market s 2.60 2.20 $ [END] -2020 +