Step 3: Creating flexible option in mine planning and development

The analysis of the various ROs has shown that the real case operation would have created value from the market uncertainty if the management had considered flexibility and treated it as an investment decision.

4.5.4.1 Option to abandon

If the management had considered an option to abandon the operations once the prices start to drop and exercised this option early rather than holding out until the company collapsed, the company would have reflected a better value. This is with the assumption that the company would have already started talking to prospective buyers who may have been ready to pay a fair, yet depreciated value in the year of exercising this option.

For this real case study, this option should have been exercised at the end of 2015. The salvage value was obtained as the median of estimated values using the diminishing value method (Australian Taxation

Office, 2013). Period in years 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 Price; US$/dmtu 129 104 94 87 80 77 73 71 69 67 66 64 64 63 63 62 Cost, US$ 512 512 512 512 512 512 512 512 512 512 512 512 512 512 512 Revenue;US$ 1,043 945 870 801 768 733 711 686 673 656 642 636 632 625 618 EBIT; US$ 531 433 358 290 257 222 199 175 161 144 131 124 121 114 106 Corporate Tax, US$ 159 130 107 87 77 67 60 52 48 43 39 37 36 34 32 Free Cash Flows, US$ 372 303 251 203 180 155 140 122 113 101 91 87 84 80 75 Discount Factor 1 1 1 1 0 0 0 0 0 0 0 0 0 0 0 DCF; US$ (1,520) 322 228 163 114 88 66 51 39 31 24 19 16 13 11 9 PV; US$ (328)

VALUING THE UNKNOWN 99

𝑉𝑎𝑙𝑢𝑒, $ = 𝑏𝑎𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 ×𝑑𝑎𝑦𝑠 ℎ𝑒𝑙𝑑

365 × 200%

4.28

The Black and Scholes (BS) model was used to value the project with an abandon option

𝑐 = 𝑆_𝑁(𝑑₁) + 𝑁(𝑑₂)𝐾𝑒2−𝑟𝑡 _4.29

with both 𝑑₁ and 𝑑₂ determined below: 𝑑₁= ln ( 𝑆 𝐾) + (𝑟 +𝑠 2 2 ) 𝑡 √𝑡 𝜎 𝑑₂= 𝑑₁− √𝑡𝜎 4.30 4.31 Where c = value of the call option, S = current stock price, t = time until option maturity, K = option strike price, r = risk-free interest rate, N = cumulative standard normal distribution, e = exponential term or constant which is ~ 2.71828, σ = standard deviation of the stock price and natural logarithm (ln). The NPV for the abandon option was calculated by discounting the present value of the project without flexibility by the yield rate or cost of delay and then taking away the capital investment that has been discounted by the risk-free rate plus the future expected salvage value that has also been discounted by the risk-free rate. Thus, the abandon option decision criteria is to abandon the operations if Max (0, X -V).

Table 4.6, NPV of the project with an option to abandon (US$’mill).

Summary of Abandon Option

Present Value of project if fund is committed $ 1,205

Annualised Standard Deviation of PV 49%

PV Variance 24%

Mine life 15.00

Investment $ 1,520

Median Salvage value if abandoned $ 407

Risk free rate 5%

Cost per year for abandonment, 1/expiry time 7%

Black - Schole Parameters

d1 = 1.384

N(d1) = 0.917

d2 = -0.494

N(D2) = 0.310

Abandon Option NPV, $M $ 243

As shown in Table 4.6, the NPV of the project with an abandon option is US$243 million which suggests the project being a worthwhile investment. Therefore, this project would have mitigated losses which the

VALUING THE UNKNOWN 100

operations incurred when the prices dropped in 2015 if the option to abandon was built into the mine plan at its inception.

4.5.4.2 Option to delay investment

A decision to invest now or to wait until the market improves is a RO whose exercise price is the capital development cost, while the underlying asset value, being an acquisition value, is the PV of net cash flows. However, each year beyond which the project is delayed, the investment foregoes cash flows that would have been earned. This cost is equivalent to 1

𝑇 , where T is the time to option expiry (Damodaran, 2015).

The Black-Scholes model was also used to value the delay option. The NPV for the delay option was calculated by discounting the present value of the project without flexibility by the yield rate or the cost of delay and then taking away the upfront capital investment that has been discounted by the risk-free rate.

Table 4.7, NPV of the project with an option to delay investment (US$’mill).

Delay Option

Present Value of project if fund is committed $ 1,205

Annualised Standard Deviation of PV 49%

PV Variance 24%

Mine life 15

Investment required for mine development $ 1,520

Risk free rate 5%

Cost per year of delay,1/expiry time 7%

Black Schole Parameters

d1= 0.682

N(d1)= 0.753

d2= -1.196

N(D2)= 0.116

Delay Option NPV,$M $ 250

As shown in Table 4.7, the NPV of the project with delays is US$250 million which is US$7 million higher than the option to start and abandon the operation. Therefore, if the management of the real case operation had considered the option to delay the investment, the operations will have mitigated the losses which occurred when prices dropped in 2015.

4.5.4.3 Staged investment option

The management of the real case operation also held an option to start a small operation for 5Mtpa that could be run by contractors using mobile crushing facilities and mining the open pit using a conventional truck and shovel system. This option provides management with the flexibility to learn more about the market and the operations can be either expanded if prices increase or discontinued whenever it becomes

VALUING THE UNKNOWN 101

unprofitable. Secondly, the benefit of this option is that there is no need to spend capital in buying mining equipment and in building the processing plant as these will be provided by the contractor. However, an initial cost of US$194 million must be paid for the development of mine services such as accommodation camp, bore field, power, pipelines for camp and concentrate processing. The cost for these services was estimated based on a similar sized mine project, being the Jupiter Mt Ida mine (Jupiter Mines Ltd, 2011) and a 10% contingency was applied to this cost (Brockman Resources, 2010). Additionally, the contractor cost for running the operations was estimated to be 25% more than the estimated owner-operated cost where 20% is the contractor profit margin and 5% is the contingency cost (Khairo and Davies, 2009). This option was valued using the stochastic model which simulates all the possible price outcomes that trigger the decision to either expand the operation when prices jump to 30% above the cost, to maintain (shrink) the current small size operation or to shut the mine when the discounted cash flows are less than zero (Fig. 4.7). The decision criteria for the option is to expand operations if prices increase if [(% of expansion * Vt ) – X] > Vt , otherwise maintain (shrink) the existing operating profile.

Table 4.8, NPV of the stochastic simulation of the option to staged investment option (US$’mill).

5.00 5.0 51.2 83.2 5% 64.0 20% 38.7 64.0 Period in years 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 Price; US$/dmtu 128.5 104.8 92.6 49.9 41.4 45.2 51.9 83.9 71.0 45.5 26.7 32.9 20.7 34.9 33.5 49.8 Free Cash Flows; US$ 143.1 200.8 (49.1) (78.8) (65.5) (42.1) 139.7 24.6 (64.5) (130.5) (108.7) (151.3) (101.8) (106.6) (49.5) Discount Factor 0.9 0.8 0.7 0.6 0.5 0.4 0.4 0.3 0.3 0.2 0.2 0.2 0.2 0.1 0.1 DCF; US$ (193.5) 123.9 150.7 - - - - 51.2 7.8 - - - - - - - Flexible Operation Expand Shut Shut Shut Shut Expand shrink Shut Shut Shut Shut Shut Shut Shut

NPV; US$ 140.1 Y N Y Y Y Y N Y Y Y Y Y Y Y

Mean NPV for 5000 Iterations; US$ 715.0

Cost of shuting; US$ Extraction rate in Mtpa

owner's operator cost; US$ Contractor Contigency cost Contractor Profit margin

Expansion Option; Mtpa

Expand if price is 30% above cost, US$/t Expansion Cost, US$/t

Mine services development cost, US$/annual t Contractor cost for mobile crushing, US$/t

VALUING THE UNKNOWN 102

Fig. 4.8, Schematic diagram of management decision for staged investment option.

From the analysis summarised in Table 4.8 and Fig. 4.8, staging the investment by starting a small operation now and expanding it in the future when prices improve has the largest NPV of US$715 million among other options. This implies that the operations would benefit from the present supported prices and would minimise large capital outlays by contracting out the operations. The real gains are embedded in the ability to expand when prices increase and scale back or discontinue operations when cash flows are less than zero. Even though such option commonly yields better value than others, staged investment option depends on the circumstances and setting of an individual project. Therefore, its outcome is a case-specific and not a generalised result.