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For purposes of this discussion, assume that you are a manager of an oil extraction firm currently considering two projects. As a manager, you...
For purposes of this discussion, assume that you are a manager of an oil extraction firm currently considering two projects. As a manager, you consider yourself to be risk-averse. The first project involves extending licenses to drill in an area of Wyoming that geologists estimate will produce up to 1 million barrels of crude oil. The second project, based in Texas, involves expanding existing wells, which are producing at a rate of 2 million barrels per month. The firm's economists predict that there is a 10 percent chance of a recession and a 90 percent chance of an economic boom. During a boom, the first project is forecasted to lose $10,000, whereas existing operations will continue to earn. $20,000. During a recession, however, the Wyoming field is projected to earn $12,000 while existing fields will lose $8,000. If the alternative is earning $3,000 on a safe asset (say, a Treasury bill), what would you do? Would you choose to expand current production by extending operations to include both projects? Would you instead concentrate on a single project? Would you instead invest in a safe asset? Why?
Document your evaluation using mean-variance analysis. Begin by summarizing the available information to document the relevant alternatives, using a tabular form such as this:
Summarize these and other factors that are essential to your decision, verbally, and using graphical representations as you find these to be applicable.
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You are the risk-averse manager of an oil extraction firm currently considering two projects. With consideration of the possible gains and losses for each project, you must decide:
- Would you choose to expand current production by extending operations to include both projects?
- Would you instead concentrate on a single project?
- Would you instead invest in a safe asset?
