Ican 2025 Strategic Financial Management Question 2

An oil company has recently acquired rights in a certain area to conduct surveys and test drillings for oil where it is found in commercially exploitable quantities. The area is already considered to have good potential for finding oil in commercial quantities. At the outset the company has the choice to conduct further geological tests or to carry out a drilling programme immediately. On the known conditions, the company estimates that there is a 70:30 chance of further tests showing a ‘success’. Whether the tests show the possibility of ultimate success or not, or even if no tests are undertaken at all, the company could still pursue its drilling programme, or alternatively consider selling its rights to drill in the area. Thereafter, however, if it carries out the drilling programme, the likelihood of final success or failure is considered dependent on the foregoing. • If ‘successful’ tests have been carried out, the expectation of success in drilling is given as 80:20; • If the tests indicate ‘failure’, then the expectation of success in drilling is given as 20:80; • If no tests have been carried out at all the expectation of success in drilling is given as 55:45. Costs and revenues have been estimated for all possible outcomes and the net present value of each is given below: Outcome Net present value N’m Success: With prior tests 100 Without prior tests 120 Failure: With prior tests -50 Without prior tests -40 Sales of exploitation rights: Prior tests show ‘success’ 65 Prior tests show ‘failure’ 15 Without prior tests 45.