Acct2114 : Real Options Analysis Assessment Answers
Question:
Given current economic conditions, BHP's risk management department believes that the price of iron ore has an equal probability going up by 20%, and going down by 20% every year for the next three years. After three years, economic conditions will have stabilised so that the price of iron ore will remain constant for the remaining life of the mine. They have also estimated BHP's cost of capital to be 10%.
1.Draw a decision tree to summarise the dilemma faced by BHP.
2. Calculate the NPV of continuing to operate the mine by working your way backwards through the tree and taking into account the option to abandon.
3.Based on your answer in (2), what should BHP do with the iron ore mine?
Answer:
BHP Mining Ltd (BHP) currently operates an iron ore mine and has commissioned CG to determine whether to continue operating the mine or to abandon it. The price of iron ore is currently $80 per ton, with the mine producing 50,000 tons of iron ore per year and costing $5 million per year to operate. In its current state, the mine has enough iron ore to continue operating for 50 years. Shutting the mine down would require BHP to bringing the land up to environmental standards, which is expected to cost $10 million. Reopening the mine once it is shut down would be an impossibility given current environmental standards.
|
As on today | |
|
Cost= $5 million per year | |
|
Revenue per tonne= $80 per ton | |
|
Production per year= 50000 tons | |
|
To abandon | ||
|
Cost of shutting down= $10 million |
|
To continue | ||
|
If prices increase |
If prices decrease | |
|
Increase in prices by 20% for three years and then stable |
Decrease in prices by 20% for three years and then stable |
|
NPV if prices goes up by 20% YoY | |||||||
|
Year |
Discounting factor @10% |
Price /ton |
Revenue |
Cost |
Net inflow |
Present Value | |
|
0 |
1.00 |
80 |
- |
- |
- |
- | |
|
1 |
0.91 |
96 |
4.80 |
5.00 |
(0.20) |
(0.18) | |
|
2 |
0.83 |
115 |
5.76 |
5.00 |
0.76 |
0.63 | |
|
3 |
0.75 |
138 |
6.91 |
5.00 |
1.91 |
1.43 | |
|
4 |
0.68 |
166 |
8.29 |
5.00 |
3.29 |
22.40 | |
|
24.28 |
|
NPV if prices decreased by 20% YoY | |||||||
|
Year |
Discounting factor @10% |
Price per tonne |
Revenue |
Cost |
Net inflow |
Present Value | |
|
0 |
1.00 |
80 |
- |
- |
- |
- | |
|
1 |
0.91 |
64 |
3.20 |
5.00 |
(1.80) |
(1.64) | |
|
2 |
0.83 |
51 |
2.56 |
5.00 |
(2.44) |
(2.03) | |
|
3 |
0.75 |
41 |
2.05 |
5.00 |
(2.95) |
(2.21) | |
|
4 |
0.68 |
33 |
1.64 |
5.00 |
(3.36) |
(22.86) | |
|
(28.74) |
NPV of the project is continued- 50% of 24.28 (+) 50% of -28.74 = (2.23)
Since there are equal chances of an increase or decrease in prices, we are taking an equal probability of the same.
|
NPV if project is discontinued | |||||||
|
Year |
Discounting factor @10% |
Price per tonne |
Revenue |
Cost |
Net inflow |
Present Value | |
|
0 |
1.00 |
- |
10 |
(10.00) |
(10.00) | ||
|
(10.00) |
Introducation:
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