Decision Tree

problem
Exercise No.3
1) The indian oil corporation is considering whether to go for an offshore oil drilling
contract to be awarded in Mumbai High. If they bid, value would be Rs. 600 million
with a 65% chance of gaining the contract. They may setup a new drilling operation or
move already existing operation, which has proved successful, to new site. The
probability of success and expected returns are as follows:

New drilling operation Existing operation

Outcome Probability Expected Probability Expected

revenue Rs. revenue Rs.
(millions) (millions)
Success 0.75 800 0.85 700
Failure 0.25 200 0.15 350

If the corporation do not bid or lose the contract they can use Rs. 600 million to
modernize their operation. This would result in a return of either 5% or 8% on the
sum invested with probabilities 0.45 and 0.55 ( Assume that all costs and revenues
have been discounted to present value.)
Construct a decision tree for the problem showing clearly the courses of action.
By applying an appropriate decision criterion, recommend whether or not the Oil
India Corporation should bid the contract.
Decision tree

39.91 5% of return (600x0.05)

0.45 =30million
Do not bid
(Modernize)
2
8% of return (600x0.08)
0.55
=48 million s s 800m
Su cce
650 e 5 0 .75
1 r tak ng Fai
lure
de illi 0 .25
Un w dr on
ne rati 200m
4 pe
s s o
u cce Mo
S 5 op veex
3 0 . 6 era isti s 700m
tio ng S ucces
n
39.9 6 0.85
Fa 5 Fai
l
0.1 ure
0.3
436.3 ilu
re 5
25
350m
Mo
7 d er 5% of return
niz 0.45
e =30 million
8 0.55
8% of return =48
• EMV at node 2=[30x0.45 + 48x0.55]=Rs.3990
• EMV at node 4 = [ 800x0.75 + 200x0.25]=Rs.650
• EMV at node 6= [700x0.85 +350x0.15]=Rs.647.50
• Therefore EMV of decision node4 =
max of [650,647.50] =Rs.650
• EMV at node 8 = [30x0.45 +48x0.55]=Rs.39.90
• Thus EMV of decision node 7= Rs.39.90
• Now, EMV of node 3 = [650x0.65 +399x0.35]
= Rs.436.325
EMV at node 3 is largest, the decision would be to bid
contract and undertake new drilling operation