You are working for Midstream Energy Partners considering a potential pipeline investment. The capital cost of the pipeline is $100 million.
If you build the pipeline, you will receive a total of between $200 million to $400 million in royalties (this is the present discounted value of royalties over the life of the pipeline; you can ignore taxes and depreciation in this problem). You may assume that these royalties are distributed uniformly between $200 million to $400 million.
Unfortunately, there is a risk of a rupture, and if the pipeline ruptures, your company will be liable for $800 million in damages. The probability of a rupture is low, however, at a level of Prupture = 0.03.
If there is a rupture, there is a 25% probability that political pressure from the state in which the rupture occurs and unwelcome attention from the US Congress and federal regulators will cause the total losses to the company to quadruple to $3.2 billion.
Note that the damages are not net of royalties. For example, if royalties are $300 million and if the pipeline ruptures causing $800 million in damages, the net payoff to the company would be: $300 million - $100 million (capital cost) - $800 million = -$600 million.
Your task is to assess whether Midstream Energy Partners should proceed with this pipeline investment. Midstream has stringent risk controls in place under which the company will not proceed with any investment that would lose $50 million or more in the worst 5% of outcomes. This needs to be done in excel.