Question

The Americo Oil Company is considering making a bid for a shale oil development contract to be awarded by the federal government. The company has decided to bid $112 million. The company estimates that it has a 60% chance of winning the contract with this bid. If the firm wins the contract, it can choose one of three methods for getting the oil from the shale. It can develop a new method for oil extraction, use an existing (inefficient) process, or subcontract the processing to a number of smaller companies once the shale has been excavated. The results from these alternatives are as follows:

Develop new process:

Outcomes Probability Profit (,000,000s)

Great success .30 $ 600

Moderate success .60 300

Failure .10 -100

Use present process:

Outcomes Probability Profit (,000,000s)

Great success .50 $ 300

Moderate success.30 200

Failure .20 -40

Subcontract:

Outcome Probability Profit (,000,000s)

Moderate success 1.00 250

The cost of preparing the contract proposal is 2 million. If the company does not make a bid, it will invest in an alternative venture with a guaranteed profit of 30 million. Construct a sequential decision tree for this decision situation and determine whether the company should make a bid.

Answer 1

Americo Oil Company must construct a sequential decision tree to evaluate the expected value of bidding for a shale oil development contract against guaranteed profits from an alternative investment. After calculating expected profits for each extraction option and subtracting the proposal cost, they can make a data-driven decision.

Step-by-step explanation:

The Americo Oil Company is faced with a decision to make a bid for a shale oil development contract and must weigh the expected profits against the alternatives. They have estimated a 60% chance of winning with their $112 million bid. If they do win, they have three options for extracting the oil. Constructing a sequential decision tree will help visualize and calculate the expected value (EV) of each option, including the development of a new process, the use of the present (inefficient) process, and subcontracting. To analyze the profitability, we need to calculate the expected profits for each option considering their associated probabilities, subtract the cost of preparing the proposal, and compare it to the guaranteed profit of 30 million from an alternative investment.

• Developing a new process has an expected profit calculated as (0.3 × $600M) + (0.6 × $300M) + (0.1 × -$100M).
• Using the present process, expected profit is (0.5 × $300M) + (0.3 × $200M) + (0.2 × -$40M).
• Subcontracting offers a guaranteed profit of $250 million.

Based on these calculations and subtracting the $2 million proposal cost, the company can then decide whether to submit a bid or to choose the alternative venture with the guaranteed profit of $30 million. This analysis will help Americo make a data-driven decision.