Corporate Finance

A Real Option’s Perspective of Capital Budgeting 
 253

The development of an oil field consists of sequential investments in test drilling, evaluation drilling, and
production capacity. The investment in test drilling is a first step in a series of investments. The decision tree
is shown in Exhibit 12.4.^4

Exhibit 12.4 Decision tree for an oil exploration project

Start test drilling

Dry Hole

Wet Hole

Appraisal drilling

Commercial Res.

Production

Abandon Continue production

Abandon

(^4) Smit, T J Han (1997). ‘Investment Analysis of Offshore Concessions in The Netherlands’, Financial Management,
Vol. 26, No. 2.