Part II: Decision Tree (15 points)

Jeff owns land that is inherited from his lovely grandfather who passed away two years ago. Recently he heard from the nearby land neighbors that there may be underground geothermal energy on the land. After a quick analysis he figured out that it will cost $600,000 to drill for the geothermal energy (i.e. water). If geothermal water exists on the land, Jeff will realize a revenue of $ 5,000,000 (i.e. not including drilling expenses). With the current information, Jeff estimates that there is a 0.3 probability that geothermal water is present on his land.

On the other hand, he can sell the land as is for $500,000 without further information about the probability of geothermal water being present.

Jeff also thinks about a third option, that is to perform geological tests on the land for a cost of $150,000. He determined that there is a 0.2 probability that the geological test results would be positive, after which Jeff can sell the land for $800,000 or drill the land with a 0.70 probability that geothermal water exists. If the test results are negative, Jeff can sell the land for $200,000 or drill the land with a 0.1 probability that geothermal water exists. Also, with this third option, the cost of drilling for the geothermal water is $600,000 and if geothermal water exists on the land, Jeff will realize the same revenue of $ $5,000,000.

Draw the decision tree for this problem that will help Jeff determine the optimal decision strategy regarding his land. Make sure that the tree is well labeled, and that you include probabilities and cash flows/payoffs as appropriate. Verbally communicate the decision strategy and its expected Payoff. (Suggestion: keep track of cash/payoff flows in units of $1,000). (15 points)