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Adjusted Real Option Valuation to Maximise Mining Project Value A Case Study Using Century Mine
S Shafiee1, E Topal2 and M Nehring3
ABSTRACT
Nowadays mining projects are seeking new versions of evaluation that are based on the flexibility in the project. Real option valuation (ROV) is one of the modern evaluation methods that provides a tool to adapt and revise mining projects under uncertainty and future variable movements. Most evaluation approaches simply assume that some variables are fixed, such as production rate, variable cost, fixed cost and lifetime of project. The first section of this paper reviews a comprehensive study of ROV in mining projects. The paper then introduces a new model that solves problems where previous methods lacked. The new method endeavours to find maximum mining project value by adding total cost as a function of production rate into ROV. The second section has been applied to a new model on the Century zinc mine in north-west Queensland, thus illustrating the future overview of that mine. The new version of ROV gave a significant positive value for the Century Mine, when the closure and reopening options where available throughout the life of the mine. Consequently, the new method evaluates real options to add value to mining projects, maximising projects value, estimating cost function, optimising production rates and offers opportunities in projects to amplify gains or to mitigate losses.

planners are unsure about the proper timing for exploration, cut-off grade and development of the mine. Consequently, in any mining project, uncertainty will increase its risk, and the mining company manager or decision maker requires flexibility to manage risks in the project (Tang, 2007). The successful evaluator during the mine life should be able to make decision to defer, expand, shrink, or abandon the project in various ways at different stages. Some strategies in a mine investment project to reduce risk and uncertainty are options, futures, swaps and hedges to explore, develop the project and sell the mineral resource. The first section of this paper reviews previous studies on ROV in non-renewable resources. The second section of this paper discusses how ROV can be used in mining projects. This is applied to the Century Mine.

LITERATURE REVIEW OF REAL OPTION VALUATION IN MINING PROJECTS

Real option valuation was launched in 1973 by the models of Black, Scholes and Merton (Black and Scholes, 1973; Merton, 1973). The real option theory was widely accepted in financial literature and more researchers attempted to modify this theory. In 1976 and 1979, Cox, Ross and Rubinstein introduced a fundamental economic principle of option pricing by arbitrage methods and gave a simple and efficient numerical procedure for valuing options (Cox and Ross, 1976; Cox, Ross and Rubinstein, 1979). For the first time, in 1985 Brennan and Schwartz evaluated a natural resources project by the Black, Scholes and Merton model. They knew that natural resources have a high degree of uncertainty in resources and pricing. The fundamental technique in ROV is based on the dynamic arbitrage4 theory. This theory presents a method to hedge assets to maximise portfolio values. The Brennan and Schwartz model showed that: the techniques of continuous time arbitrage and the stochastic control theory may be used not only to value such projects, but also to determine the optimal policies for developing, managing, and abandoning them (Brennan and Schwartz, 1985a, 1985b). McDonald and Siegel illustrated that an essential lesson from microeconomics theory is that a project should be shut down if operating revenues are less than variable costs (McDonald and Siegel, 1985). This straightforward theory introduced this initial question of whether and when a project should be opened or closed. Trigeorgis and Mason provided some examples of applied real option valuation on several different projects (Trigeorgis and Mason, 1987; Trigeorgis, 1996). They demonstrated options to defer, expand and close numerous investment project decisions, especially within the natural resource environment. They illustrated that making decisions on natural resource projects significantly depend on commodity price fluctuations. In 1988 Paddock and his colleagues extended the financial option theory for the valuation of an offshore petroleum lease (Paddock, Siegel and Smith, 1988). This applied paper concluded that the option to defer a petroleum project is an alternative to prevent bankruptcy in the future. Applied ROV in other projects is used by Quigg in 1993, which tested empirical real option price modelling on a

INTRODUCTION
Investment in mining projects is slightly different in comparison with investing in other projects. Most mine investment projects comprise three factors. Firstly, the investment is partially or completely irreversible. This means that capital investment is required to establish the operation, with the initial investment not able to be recouped. Secondly, there is uncertainty over the future rewards from the investment. Some of these variables may have significant effects on the mines future, such as commodity prices, orebody characteristics and operating cost. Finally, the investor has some leeway in regard to the timing of the investment. In reality, the investment in a mine does not happen immediately; there is a delay between making the decision to mine and the investment occurring in the project. These three factors interact to determine the optimal decisions of investment (Drieza, Kicki and Saluga, 2002; Topal, 2008). Mining projects are comprised of different complex aspects but all have the same direction. The mining company managers are trying to evaluate the mine with uncertainties that are inherently attached to mining projects. For example, geologists are uncertain about the size of the orebody, metallurgists are uncertain about the recovery, mineral economists have doubts about the prices of mineral and exchange rates, and mine
1. PhD Student, School of Mining Engineering, Frank White Building (#43), Cooper Road, CRC Mining, University of Queensland, St Lucia Qld 4072. Email: s.shafiee@uq.edu.au Senior Lecturer and Senior Researcher, School of Mining Engineering, Frank White Building (#43), Cooper Road, CRC Mining, University of Queensland, St Lucia Qld 4072. Email: e.topal@uq.edu.au GAusIMM, PhD Student, School of Mining Engineering, Frank White Building (#43), Cooper Road, CRC Mining, University of Queensland, St Lucia Qld 4072. Email: m.nehring@uq.edu.au The simultaneous purchase and sale of an asset in order to maximise trading profit from a difference in the price. Arbitrage usually takes place on different exchanges or marketplaces. For more information refer to Zhang, Xu and Deng (2002).

2.

3.

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large sample of market prices for real estate by using econometrics models to incorporate the option to develop the land or wait for the future (Quigg, 1993). Moreover, in 1996, Berger and his colleagues examined the abandonment option of a firm and investigated the real option theory postulate that the abandonment option was valuable (Berger, Ofek and Swary, 1996). Additionally, some other researches applied ROV in natural resources, mining, oil and gas concluding that options to defer, alter, switch and shut down projects increased their value (Kulatilaka and Marcus, 1992; Laughton and Jacoby, 1993; Pickles and Smith, 1993; Kulatilaka and Trigeorgis, 1994; Mauer and Ott, 1995; Palm and Pearson, 1986; Cavender, 1992). Consequently, real option theory was introduced as a new method in appraisal for a variety of industries. After Brennan and Schwartz, Mardones in 1993 applied financial option theory as an application of contingent claims analysis (CCA), or derivative asset valuation (DAV) to obtain the value added by managerial flexibility in a copper project in Chile (Mardones, 1993). The operating flexibility valued in this application consists of the possibility of modifying the cut-off grade strategy each time copper prices change unexpectedly; cut-off grade strategy is following by an inter-temporal cut-off grade optimising model. This illustrates the increase in mine value associated with flexibility. In 1996, Laughton carried out modern asset pricing (MAP) or option pricing (OP) methods for analysing mining financial structure. These techniques allow more precise comparative analyses of the effects of time, uncertainty, project structure and the potential for management on the value of the decision alternatives that the manager faces. Nowadays, MAP and OP have been known as ROV in financial literature. He compared MAP with DCF methods and proved that DCF tends to undervalue long life mines relative to MAP (Laughton, 1996). Samis and Poulin demonstrated that: Project value is influenced by economic and physical environmental uncertainties, a dynamic project risk structure and the possibility of multiple and mutually exclusive project uses. The DCF is widely used in the mining projects even though it is unable to account for these influences on project value (Samis and Poulin, 1996). In other words, the MAP valuation techniques extended the valuation further by examining the project with different combinations of management flexibility (Samis and Poulin, 1998). Samis and Poulin in two different papers evaluated copper and gold mines and calculated project value by DCF and ROV techniques, concluding that ROV was more flexible and suitable for mining projects compared with DCF. In 1987 Frimpong and Whiting evaluated a copper mine by using the derivative mine valuation and conventional methods. Their results indicated that the new method of mine valuation allows investors to maximise the ventures market value by exercising options. In other words, he concluded modern evaluation techniques increase a mines profit in comparison with classical techniques (Frimpong and Whiting, 1997). In 1998, Salahor described how MAP may be used for oil and gas project evaluation. Salahor divided cash flows into two components: revenue and cost. This paper added flexibility in these two components in different scenarios (Salahor, 1998). In 1998, some similar research added flexibility in mining and oil projects in the same way, concluding that using DCF methods can result in false project valuation. Biases into the analyses that lie behind project design and selection as well as flexibility increasing the profit of the mining and oil project can result in false project valuation (Smith and McCardle, 1999; Kelly, 1998; Sagi, Hiob and Jones, 1998; Paddock, Siegel and Smith, 1988; Cortazar and Casassus, 1998; Dunbar, Dessureault and Scoble, 1998).

Most of the applied ROV papers used a hypothetical or simple example of mining or oil projects encountered in practice, and compared traditional discounted cash flow analysis with ROV (McKnight, 2000). Using option pricing and decision analysis approaches in practice is more complicated. Therefore, many resource projects are using DCF analysis rather than ROV. Some ROV variables are required for evaluating options in nonrenewable projects that are not available, due to the link between ROV in finance with mining and oil projects at some stages are impossible. Consequently, earlier in the decade some new researchers attempted to introduce easier versions of ROV that can be used in reality for the evaluation of non-renewable projects (Camus and Pelley, 1999; Faiz, 2001; Drieza, Kicki and Saluga, 2002; Bailey et al, 2004). The following researchers apply flexibility in mining to a range of real mining operations. Slade in 2001, Moel and Tufano in 2002, Colwell and colleagues in 2003 and Kelley in 2004 individually valued managerial flexibility for 21 copper mines in Canada, 285 gold mines in the USA, 27 gold companies in Australia and for 41 gold mines in Australia respectively. These researchers concluded that the flexibility in mine projects is significant, leading to mining projects to open, defer or shut down under different circumstances (Kelly, 2004; Slade, 2001; Moel and Tufano, 2002; Colwell et al, 2003). Recently, some empirical evidence in mining and oil projects has shown that shut down or temporary closure of projects increased profit by using ROV in comparison with DCF (Blais, Poulin and Samis, 2005; Dessureault, Kazakids and Mayer, 2007; Guj and Garzon, 2007; Samis et al, 2006). Moreover some research in hypothetical examples concluded that ROV is an appropriate method for mining companies because operational flexibilities are deemed an essential component of mining and oil project values (Hall and Nicholls, 2007; Dogbe, Frimpong and Szymanski, 2007; Shafiee and Topal, 2008a). As a result mining companies are increasingly interested in flexibility in mining projects and change their methods accordingly (Moel and Tufano, 2002). Nevertheless, some mine managers still can not digest how to deal with temporary or permanent closure of the project. Most mine company managers still consider continuation of mining until the depletion of the ore body without considering any flexibility as best practise. Table 1 shows all previous empirical studies on ROV and DCF in mining projects. As can be seen in this Table, most of the study focused on hypothetical mining projects, which account for around 70 per cent. The main reason data is not available is due confidentiality issues. For this reason, it is difficult to validate the models. Consequently, this paper used data from annual reports containing Century Mine information.

NEW MODEL FOR THE VALUE OF THE OPENED MINE

This research endeavours to introduce a new method to find maximum mining project value by simulating the cost function as production rates into ROV model. The cost functions, permanent and temporary closing cost and reopening cost have been estimated in the new method. In other words, this research discovers a relationship between production rates and total cost, then demonstrates how simulation in ROV can figure out the maximum mining value. The increasing production rates in real option valuation will calculate extra value in mining projects that is possibly hidden or even invisible when traditional evaluation techniques are used alone. One of the significant advantages of this method is being able to evaluate mining projects in different scenarios at the beginning of the project. The mining project would have responded by changing production rates there by capitalising on the new circumstances of the project. The most important variables that have affected the value of the opened mine are mineral commodity price, the size of reserve, time and mine operation policy. The mine operating policy demonstrates the options in mining to open, close, expand,

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TABLE 1
Empirical evidence of the ROV and DCF in operating non-renewable commodities.
No 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 Year 1985a 1985b 1986 1988 1992 1992 1993 1993 1993 1994 1996 1996 1997 1998 1998 1998 1998 1998 1998 1998 1999 1999 2000 2001 2001 2002 2002 2003 2004 2004 2005 2006 2007 2007 2007 2007 2008 Author(s) M J Brennan, E S Schwartz M J Brennan, ES Schwartz S K Palm, N D Pearson J L Paddock, D R Siegel, J L Smith N Kulatilaka, A J Marcus B Cavender D G Laughton, H D Jacoby J L Mardones E Pickles, J L Smith N Kulatilaka, L Trigeorgis D G Laughton M Samis, R Poulin S Frimpong, J Whiting G Salahor M Samis, R Poulin G Cortazar, J Casassus W S Dunbar, S Dessureault, M Scoble W S Dunbar, S Dessureault, M Scoble J S Sagi, E E Hiob, S Jones S Kelly J E Smith, K F McCardle J P Camus, C W Pelley R T McKnight M E Slade S Faiz J A Drieza, J Kicki, P Saluga A Moel, P Tufano D Colwell, T Henker, J Ho, K Fong W Bailey, A Bhandari, S Faiz, S Srinivasan, H Weeds S Kelly V Blais, R Poulin, M Samis M Samis, G A Davis, D Laughton, R Poulin J Hall, S Nicholls S Dessureault, V N Kazakidis, Z Mayer P Guj, R Garzon G Dogbe, S Frimpong, J Szymanski S Shafiee, E Topal Method ROV ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV ROV ROV ROV DCF, ROV DCF, ROV DCF DCF, ROV DCF, ROV DCF, ROV DCF, ROV ROV DCF, ROV ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV DCF, ROV Commodity Copper Gold Copper Oil Oil, gas Gold Oil Copper Oil Oil Copper Gold Copper Gas Copper Copper Underground mine Gold Copper Gold Oil, gas Copper Copper Copper Oil Zinc, lead Gold Gold Gas Gold Cooper, gold Copper Coal Nickel, copper Nickel Copper Gold Mine/project name Hypothetical Hypothetical Not available Gulf of Mexico Not available Hypothetical Not available Not available Not available Hypothetical Not available Not available Confidential Not available Not available Not available Not available Not available Not available Lihir Island Hypothetical Not available Not available 21 mines Chevron Texaco Olkusz Pomorzany 285 mines 27 companies Elba Island 41 mines Not available Not available Hypothetical Sudbury, Western Arizona Not available Hypothetical Hypothetical Project location Not available Not available Not available USA Not available USA Not available Chile USA Not available Not available Not available Not available Not available Not available Not available Not available Not available Not available Papua New Guinea Not available Not available Not available Canada USA Poland North America Australia Georgia Australia Canada Not available Not available Canada, USA Not available Not available Australia

shrink or abandon. Hence the value of the operating mine should be similar to Equation 1 (Colwell et al, 2003): V = V (S, Q, t, j, ) where: V S Q t is the value of the open mine is the mineral commodity price is the total mine reserve is the calendar time (1)

is the binomial variable, value of one if the mine is open and zero if it is closed is the mine operating policy represents the set of opening, closing and abandoning

This model has been modified by Colwell in 2003, where by it was assumed that some variables are constant. In other words, Colwell made a simple version of the Brennan and Schwartz model. In the original model, one of the significant variables was time. This model assumed that the extraction cost and convince yield were dependent on time. Consequently, in this comprehensive model all of the variables are considered.

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For simplicity, the Brennan and Schwartz model have ignored the depreciation tax allowances. The new model calculated free cash flow to the firm (FCFF) in Equation 2: n FCFFt = [( pit VC it ). PRit ] FC t .(1 T ) i=1 where: FCFFt Pit VCit PRit FCt T n is free cash flow to the firm at time t is mineral commodity price for commodity i at time t is variable cost for commodity i at time t is production rate for commodity i at time t is fixed cost at time t is corporative tax is the number of mineral commodities in different grade (2)

temporary closing cost and reopening cost of the mine. These three functions should be estimated for the entire mine life. This means the option comprehensively is comparing value of mine with all other opportunities in each time. In the following equation, the production rate could be optimised with commodity price movement for each period. The ROV model is illustrated in the following formula: ROVtk = Max 0 D1 PCC t D2 TCC t , FCFFtk + p. ROVt + 1 k + (1 p ). ROVt + 1 k 1 (1 + rf ) D1 PCC t D2 TCC t D3 ROC t where: ROVik is real option valuation in period t and arch k

(7)

This new model estimates the total cost function individually for each mining project. In other words, the new contribution of this model has added total cost functions in the model as variable terms. The important question in practice is how to estimate the function of cost. In theory, total cost is a function of capital (K) and labour (L). In the mining projects, the mineral commodity price (P) and production rate (PR) have a very significant influence on total cost. Finally, an econometrics model will estimate the cost functions. Then the following equations show variable cost and fixed cost functions respectively: VCit = f (K, L, Pit , PRit ,...) FCt = g (K, L, P1t , P2t ,..., Pnt , PR1t , PR2t ,..., PRnt ,...) where: K L is mining project capital is mining project labour (3) (4)

FCFFik is free cash flow to the firm in period t and arch k D1 D2 D3 P rf PCC TCC ROC = 1 if the mine is going to close permanently in period t, otherwise D1 = 0 = 1 if the mine is going to close temporary in period t, otherwise D2 = 0 = 1 if the mine is going to reopen in period t, otherwise D3 = 0 is the risk neutral probability is the risk free rate of interest is permanent closing cost of mine is temporary closing cost of mine is reopening cost of mine

If we are substituting Equation 3 and 4 in Equation 2, we will reach the following equation: FCFFt =

[( P
i=1

it

f ( K , L, Pit , PRit ,...). PRit ] (5)

g( K , L, P1 t , P2 t ,..., Pnt , PR1 t , PR2 t ,..., PRnt ,...) .(1 T ) In Equation 5, all of the variables are exogenous except production rate. In other words, FCFF is depending on production rate for each node. Then the DCF will calculate according to the following formula: DCF = where: r is the discounted rate for mining project The DCF mathematically is a function of PR; then it is possible to maximise the DCF to find out the optimal mine production rate with commodity price movement. After describing the value of the mining projects and FCFF from the mine operation, it is time to introduce the ROV model. This model calculates mine value according to FCFF. The advantage of this model is comparing mine value with closing cost and reopening cost in each period. Equation 7 has added three opening and cost functions: permanent closing cost,
n

t +1

FCFFt (1 + r )t

(6)

As can be seen in Equation 7 the reopening cost and closing cost need to be estimated for calculation of ROV. One of the advantages of this model is that the estimated reopening and closing cost is a function for each period. The main approach to estimate cost functions for this model uses econometrics techniques, such as ordinary least square (OLS), quasi-maximum likelihood estimation (QMLE) and generalised method of moments (GMM). In other words, according to available scenarios of costs and influenced variables, the cost functions would be regressed. The big issue of this model is calculating the mine value in anytime and simulating the production rate to optimise it for maximising mining project value. In applied ROV in non-renewable resources, Brennan and Schwartz in their model assumed that the mine has only two possible operating rates; constant production rate when open and zero rate when closed. In the new version of the Brenan and Schwartz model, the production rate is relative to the mineral commodity price. Moreover, the costs are a function of production rate and mineral commodity price. Then the mineral commodity price movement influences the mine production rate. The following equations show different alternatives in different prices: 0 S < S 1 q = 0, Mine should be permanently closed S 1 S < S 2 q = 0, Mine should be temporarily closed (8) S 2 S < S 3 q = Optimum, Mine is open S 3 S q = Max, Mine should expand where: S1 is the threshold of mineral commodity price that mine will be abandonment

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S2 S3

is the threshold of mineral commodity price that mine will be waiting is the threshold of mineral commodity price that mine will be open

THE CENTURY ZINC MINE

This section demonstrates how the new ROV model is applied to the Century Mine located in the Gulf region of north-west Queensland. For this purpose, data5 for the Century Mine has been collected to calculate and compare DCF and ROV methods. The Century Mine is the largest zinc mine in Australia and the second largest in the world after the Red Dog Mine in Alaska. Conventional open pit mining methods are utilised at Century Mine. The orebody is relatively flat, with a rectangular geometry of around 1.4 by 1.2 km and 0.34 km deep. The truck and shovel fleet moves more than 100 million tonnes of material a year including approximately five million tonnes of ore. Century produces a zinc concentrate, lead concentrate as well as silver. Processing methods are via conventional grinding and flotation. Table 2 shows all key statistics about Century Mine from 2000 to 2008 (OZ Minerals, 2008). As can be seen in Table 2 reserve estimation for Century Mine was not very accurate in the last couple of years by comparing mine production with mine reserve. Furthermore, price fluctuation does not have any significant effect on mine reserve. The same conclusion could be driven for the non-renewable resources as well (Shafiee and Topal, 2008b, 2009).
5. The most data for the Century Mine came from annual reports from Pasminco, Zinifex and OZ Minerals. Nevertheless, not all of the data was homogenous and available, therefore not explicitly available data was estimated.

The initial investment for Century Mine was about $733 million over the construction phase with production commencing in 2000. At current commodity prices, the NPV of the Century Mine is calculated to be around $20 million. According to reserve estimates, the Century Mine could continue production at current levels until 2020. This evaluation assumes annual financial computations. The depreciation, amortization and maintenance capital expenditure is assumed to be zero. The reopening costs (ROC) and temporary closure costs (TCC) for the Century Mine has been estimated to be around $120 million in 2008. Permanent closure costs (PCC) has been estimated to be $500 million in todays real terms. The cost estimations are adjusted by the risk free rate for the entire life-of-mine, as can be seen in Table 3. The volatility of cash flow from mine reserves is assumed to be 30 per cent, the risk-free interest rate is seven per cent, weighted average cost of capital is 15 per cent and corporate tax rate is 30 per cent. For evaluation of the Century Mine, two methods have already used DCF and ROV. The first approach is not flexible; however, the second one is flexible throughout mine life. Before moving to calculate DCF, the zinc price fluctuations via binomial price modelling (BOP) are calculated (Zhang, Xu and Deng, 2002). The fluctuations in the zinc price are required by binomial option pricing model to obtain the range of future zinc prices. Moreover, upside change and downside change of price in BOP is: u = e 1 d= u
T N

(9)

TABLE 2
Total production, grade, reserve and resource in Century Mine from 2000 to 2008.
Year Ore production (Mt) Grade (% Zn) Grade (% Pb) Grade (g/t Ag) Zinc production (t) Lead production (t) Silver production (kg) Reserve (Mt) Grade (% Zn) Grade (% Pb) Grade (g/t Ag) Resources (Mt) Grade (% Zn) Grade (% Pb) Grade (g/t Ag) 106 734 96.9 11.6 1.6 43 102.4 12.2 1.7 45 2000 1.41 11.1 3.5 86.2 184 444 2001 4.78 11.7 2.4 62 416 880 53 770 185 656 83.9 11.6 1.6 42 89.3 13.2 1.7 46 2002 4.85 12.7 2.3 59 470 706 88 322 203 660 75 12.2 1.6 38 83.6 13.3 1.7 44 2003 5.16 12.6 1.7 51.2 520 322 65 020 197 016 68.8 11.8 1.5 32 78.4 13.2 1.7 43 2004 5.18 12.8 1.7 49.2 510 200 54 320 180 000 62.2 11.8 1.4 31.5 72.2 13 1.6 40 2005 5.2 13 1.6 48 501 480 49 860 180 000 55.7 11.9 1.3 31 66.7 12.7 1.5 38 2006 5.12 13.2 1.6 46.4 510 420 56 000 180 000 52.1 11.5 1.2 27 60.3 12.7 1.4 34 2007 5.08 13.4 1.5 44.8 514 100 65 000 180 000 47.02 11.5 1.2 27 57.02 12.7 1.4 34 2008 5.02 13.6 1.5 43.3 516 964 71 384 180 000 42 11.5 1.2 27 52 12.7 1.4 34

Sources: Pasminco, 1999, 2000, 2001, 2002, 2003; Zinifex, 2005, 2006, 2007.

TABLE 3
The reopening costs (ROC), temporary closing cost (TCC) and permanent closing cost (PCC) for Century Mine from 2008 to 2020 ($M).
Year ROC and TCC PCC 2008 120 500 2009 128 535 2010 137 572 2011 147 613 2012 157 655 2013 168 701 2014 180 750 2015 193 803 2016 206 859 2017 221 919 2018 236 984 2019 253 1052 2020 270 1126

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where: u d T N is upside change of price is downside of price is number of years to expiration is number of binomial periods

The BOP upside and downside changes for zinc price are estimated at 1.35 and 0.74 respectively according to following formulas: u=e
0 .3 3 3

= 1.35

1 d= = 0.74 1.35 In Table 4, the binomial tree of the zinc prices for 12 years is illustrated. To calculate the upside node zinc price in 2009, the zinc price in 2008 would be multiplied by the upside factor (0.8 1.35 = 1.08) and for downside node the zinc price in 2009
6. The risk neutral measure is the probability measure that results when one assumes that the future expected value of all financial assets are equal to the future pay-off of the asset discounted at the risk-free rate.

should be multiplied by the downside factor (0.8 0.74 = 0.59). Consequently, to work out the range of zinc prices up to 2020, a similar approach has been utilised. In order to calculate the DCF for zinc price movements, the free cash flow to the firm (FCFF) needs to be calculated. Table 5 demonstrated FCFF for the Century Mine. The calculation does not add any temporary closing cost and reopening cost. The next step adds these costs and the FCFF together. As can be seen in Table 5 free cash flow to the firm in some stages is negative or positive. For instance, the upside FCFF2009 is positive $120 million while the downside is negative $-268 million. This means, when the zinc price goes up the FCFF is increasing and vice versa when zinc price goes down. Table 5 illustrates the FCFF for all 12 years of the project according to zinc price movements. In the binomial tree of zinc price, upside and downside change of price has an individual probability for each node within the tree. Therefore, to show the probability of each node, the risk neutral probability needs to be calculated. Consequently the risk neutral probability6 of a rise in value is: p= (1 + rf ) d ud (10)

TABLE 4
Binomial tree of zinc price from 2008 to 2020 ($/ounce).
2008 0.80 2009 1.08 0.59 2010 1.46 0.80 0.44 2011 1.97 1.08 0.59 0.33 2012 2.66 1.46 0.80 0.44 0.24 2013 3.59 1.97 1.08 0.59 0.33 0.18 2014 4.84 2.66 1.46 0.80 0.44 0.24 0.13 2015 6.53 3.59 1.97 1.08 0.59 0.33 0.18 0.10 2016 8.82 4.84 2.66 1.46 0.80 0.44 0.24 0.13 0.07 2017 11.90 6.53 3.59 1.97 1.08 0.59 0.33 0.18 0.10 0.05 2018 16.07 8.82 4.84 2.66 1.46 0.80 0.44 0.24 0.13 0.07 0.04 2019 21.69 11.90 6.53 3.59 1.97 1.08 0.59 0.33 0.18 0.10 0.05 0.03 2020 29.28 16.07 8.82 4.84 2.66 1.46 0.80 0.44 0.24 0.13 0.07 0.04 0.02

TABLE 5
Free cash flow to the firm ($M).
2008 -54 2009 120 -268 2010 370 -155 -443 2011 721 13 -376 -589 2012 1211 255 -270 -558 -716 2013 1888 598 -110 -499 -712 -829 2014 2821 1079 123 -401 -689 -847 -934 2015 4099 1748 457 -251 -639 -853 -970 -1034 2016 5844 2670 929 -27 -552 -840 -998 -1084 -1132 2017 8222 3938 1587 296 -412 -801 -1014 -1131 -1195 -1230 2018 11 454 5672 2498 756 -200 -724 -1012 -1170 -1257 -1305 -1331 2019 15 843 8037 3753 1402 112 -596 -985 -1198 -1315 -1380 -1415 -1434 2020 21 794 11 257 5474 2300 559 -397 -922 -1210 -1368 -1454 -1502 -1528
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The risk neutral probability has found to be as 0.54 by using the following formula: p= 1.07 0.74 = 0.54 1.35 0.74

the econometrics model, the following equation for total cost has been estimated for 2008: TC = 187.(1 + rf )n + 1552. PR.(1 + rf )n 142 43 1442 443
TFC TVC

(11)

This figure means that there is a 54 per cent chance that the zinc price will increase 35 per cent and 46 per cent chance that the zinc price will decrease 26 per cent. Table 6 demonstrates the probability distributions of all zinc price movements. Risk neutral probability up to the end of 2020 has been calculated in Table 6. The total cost incurred to produce zinc at Century has been estimated from 2000 to 2008. These costs include operating, transport, smelting, by-product credit and royalties. Table 3 compares the difference between the average zinc price and total cost for Century Mine over the last nine years. As can be seen in Figure 1, Century Mine had losses from 2001 to 2003, and gains from 2004 to 2007. Andrew Michelmore, Chief Executive of OZ Minerals, said average total cost at Century is close to the global average cost. This means, if the zinc price does not go up in the near future, some zinc mines in the world will need to curb their production.
1.80

Total cost (TC) includes total fixed cost (TFC) and total variable cost (TVC). The coefficients in Equation 11 have been estimated for 2008, then the coefficients adjusted via risk free interest rate (rf) for entire mine life. This equation is used to calculate the FCFF for the next 12 years for the project. The risk free rate has been added to the function for adjusting risk in calculating total cost for each year, individually. Table 7 calculates discounted cash flow valuation for Century. FCFF in the last year of the project (in this example year 2020) shows the value of discounted cash flow of the mine for the last year. This means that the last column in Table 5 is the same as the last column in Table 7. For calculating the remaining years, the following equation is used. For example to calculate DCF in the first node of 2009, the formula should be: DCF2009 1 = FCFF2009 1 + DCF2009 1 P. DCF2010 1 + (1 p ). DCF2010 2 (1 + rf )

Zinc Price
1.50

Zinc cost

(12)

1.20

( 0.54).( 4068) + (1 0.54).( 1703) = 1444 = 120 + 1 + 0.07

$/oz

0.90

where: DCF2009-1 is discounted cash flow in 2009 in the case where zinc price is $1.08

0.60

0.30

FCFF2009-1 is free cash flow to the firm in 2009 in the case where zinc price is $1.08
2000 2001 2002 2003 2004 2005 2006 2007 2008

0.00

DCF2010-1 DCF2010-2 P Rf

is discounted cash flow in 2010 in the case where zinc price is $1.46 is discounted cash flow in 2010 in the case where zinc price is $0.80 is the risk neutral probability is the risk free rate

FIG 1 - The zinc price and average total cost of zinc per ounce from 2000 to 2008 for Century Mine.

One of the advantages of this model is that the cost function has been estimated dependent on production rate. The total cost function is a dynamic equation that will change in time, making the equation multivariable. This evaluation for simplicity has assumed that the total cost function has just one dependent variable while the others are constant. According to the data and relationship between production rate (PR) and total cost (TC) via

The discounted cash flow with zinc price fluctuations is computed as -$708 million if Century remains open until 2020. The negative net present value (NPV) shows the project is not economical and Century zinc mine should be closed. As can be

TABLE 6
Risk neutral probability distribution.
2008 1 2009 0.54 0.46 2010 0.29 0.50 0.21 2011 0.16 0.40 0.34 0.10 2012 0.09 0.29 0.37 0.21 0.04 2013 0.05 0.20 0.33 0.28 0.12 0.02 2014 0.02 0.13 0.27 0.31 0.20 0.07 0.01 2015 0.01 0.08 0.20 0.29 0.25 0.13 0.04 0.00 2016 0.01 0.05 0.15 0.25 0.27 0.18 0.08 0.02 0.00 2017 0.00 0.03 0.10 0.20 0.26 0.22 0.12 0.05 0.01 0.00 2018 0.00 0.02 0.07 0.16 0.23 0.24 0.17 0.08 0.03 0.00 0.00 2019 0.00 0.01 0.05 0.12 0.20 0.24 0.20 0.12 0.05 0.01 0.00 0.00 2020 0.00 0.01 0.03 0.08 0.16 0.22 0.22 0.16 0.08 0.03 0.01 0.00 0.00

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seen, DCF methods with zinc price movements do not have any flexibility and concluded that Century Mine should be shut down. Consequently, the DCF depends on input variables, unchangeable across project life and provides only one view across time. The second method is ROV which considers volatility and manages the risk in evaluating the zinc mine. This method assumed that all production occurs at the end of the year. Moreover, the mine may open and close many times during the mine life in order to maximise mine value. In the following sections, ROV add these assumptions to calculate ROV for the Century zinc mine. To calculate the American call option in 2008, the call option should be calculated at the end of the period. In other words, the zinc price at the end of the period will be compared with the total cost of zinc production using the following formula: C = Max (0, St - X) where: St X is stock price or NPV of developed mine reserves is exercise price or NPV of expenditure to develop reserve (13)

and reopening cost are added to the calculation. Table 8 compares the maximum value of developed mine reserve and expenditure to develop reserve with zero. This means the positive values of DCF in 2020 from Table 6 has moved in 2020 in Table 7 and negative values are turned to permanently closing cost. Moreover, the temporary closing cost and reopening cost have added some stages such that the mine has closed or reopened. The rest of the valuations of cash flow for mine are computed by risk neutral probability, for example, ROV2009-1 is calculated as following formula: ROV2009 1 + Max 0 D1 . Pcc, FCFF2009 1 + P. ROV2010 1 + (1 p ). ROV2010 2 D1 . TCC D2 . ROC (1 + rf ) (14) ROV2009 1 + Max 0 ( 0 ).( 535),120 + ( 0.54).( 4727) + (1 0.54).( 522 ) ( 0 ).(128) ( 0 ).(128) (1 + 0.07) = 2732

Table 8 shows the real option valuation of cash flows for the next 12 years. In American options, the mine has a chance to reopen and close several of times. Nevertheless, the closing cost

TABLE 7
Discounted cash flow valuation ($M).
2008 -708 2009 1444 -3220 2010 4068 -1703 -4870 2011 7211 129 -3757 -5890 2012 10 897 2294 -2427 -5019 -6441 2013 15 107 4785 -880 -3989 -5695 -6632 2014 19 747 7555 863 -2809 -4824 -5930 -6537 2015 24 592 10 486 2744 -1505 -3836 -5116 -5818 -6204 2016 29 220 13 352 4643 -136 -2759 -4199 -4989 -5422 -5660 2017 32 886 15 750 6346 1185 -1648 -3202 -4055 -4524 -4780 -4922 2018 34 363 17 015 7494 2269 -599 -2173 -3037 -3511 -3771 -3914 -3992 2019 31 686 16 074 7506 2804 223 -1193 -1970 -2397 -2631 -2759 -2830 -2868 2020 21 794 11 257 5474 2300 559 -397 -922 -1210 -1368 -1454 -1502 -1528 -1542

TABLE 8
Real option valuation of cash flows ($M).
2008 1298 2009 2732 -64 2010 4727 522 -137 2011 7380 1465 -147 -613 2012 10 686 2937 -73 -157 0 2013 14 628 4858 532 -168 -701 0 2014 19 082 7221 1424 -180 -750 0 0 2015 23 809 9859 2706 -154 -193 0 0 0 2016 28 361 12 538 4140 367 -206 -859 0 0 0 2017 31 967 14 831 5533 969 -221 -919 0 0 0 0 2018 33 379 16 031 6510 1533 -236 -984 0 0 0 0 0 2019 30 633 15 022 6454 1752 -253 -1052 0 0 0 0 0 0 2020 20 668 10 131 4348 1174 -567 -1126 0 0 0 0 0 0 0

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ADJUSTED REAL OPTION VALUATION TO MAXIMISE MINING PROJECT VALUE

where: ROV2009-1 is real option valuation in year 2009 in the case where zinc price is $1.08 FCFF2009-1 is free cash flow to the firm in year 2009 in the case where zinc price is $1.08 ROV2010-1 is real option valuation in year 2010 in the case where zinc price is $1.46 ROV2010-2 is real option valuation in year 2010 in the case where zinc price is $0.8 D1 D1 D2: D1 D1 P rf PCC TCC ROC = 1 if the mine is going to close in this year (year 2009) = 0 if the mine was closed in last year (year 2008) = 1 if the mine is reopening this year (year 2009) = 0 if the mine was opened in last year (year 2008) is the risk neutral probability is the risk free rate of interest is permanent closing cost of mine is temporary closing cost of mine is reopening cost of mine

REFERENCES
Bailey, W, Bhandari, A, Faiz, S, Srinivasan, S and Weeds, H, 2004. Unlocking the value of real options, Oilfield Review, winter, pp 4-19. Berger, P G, Ofek, E and Swary, L, 1996. Investor valuation of the abandonment option, Journal of Financial Economics, 42:257-287. Black, F and Scholes, M, 1973. The pricing of options and corporate liabilities, The Journal of Political Economy, 81:637-654. Blais, V, Poulin, R and Samis, M R, 2005. Using real options to incorporate price risk into the valuation of a multi-mineral mine, in Orebody Modelling and Strategic Mine Planning (ed: R Dimitrakopoulos), pp 9-16 (The Australasian Institute of Mining and Metallurgy: Melbourne). Brennan, M J and Schwartz, E S, 1985a. Evaluating natural resource investments, Journal of Business, 58:135-157. Brennan, M J and Schwartz, E S, 1985b. A new approach to evaluating natural resource investments, Midland Corporate Finance Journal, 3:37-47. Camus, J P and Pelley, C W, 1999. The opportunity cost in mine planning, in Proceedings 101st Annual General Meeting of the Canadian Institute of Mining, Metallurgy and Petroleum (Canadian Institute of Mining, Metallurgy and Petroleum: Montral). Cavender, B, 1992. Determination of the optimum lifetime of a mining project using discounted cash flow and option pricing techniques, Mining Engineering, October, pp 1262-1268. Colwell, D, Henker, T, Ho, J and Fong, K, 2003. Real option valuation of Australian gold mines and mining companies, The Journal of Alternative Investments, summer, pp 23-38. Cortazar, G and Casassus, J, 1998. Optimal timing of a mine expansion: Implementing a real options model, Quarterly Review of Economics and Finance, 38:755. Cox, J C and Ross, S A, 1976. The valuation of options for alternative stochastic processes, Journal of Financial Economics, 3:145-166. Cox, J C, Ross, S A and Rubinstein, M, 1979. Option pricing: A simplified approach, Journal of Financial Economics, 7:229-263. Dessureault, S, Kazakids, V N and Mayer, Z, 2007. Flexibility valuation in operating mine decisions using real options pricing, International Journal of Risk Assessment and Management, 7:656-674. Dogbe, G, Frimpong, S and Szymanski, J, 2007. Mineral reserve risk in continuous-time stochastic mine valuation, International Journal of Risk Assessment and Management, 7:675-694. Drieza, J A, Kicki, J and Saluga, P, 2002. Real options in mine project budgeting Polish mining industry example, in Risk Analysis III (ed: C A Brebbia) (WIT Press: Southampton). Dunbar, W S, Dessureault, S and Scoble, M, 1998. Modeling of flexible mining systems, in 100th Annual General Meeting of the Canadian Institute of Mining, Metallurgy and Petroleum (Canadian Institute of Mining, Metallurgy and Petroleum: Montral). Faiz, S, 2001. Real options application: From success in asset valuation to challenges for an enterprise wide approach, Journal of Petroleum Technology, 53:42-47. Frimpong, S and Whiting, J M, 1997. Derivative mine valuation: Strategic investment decisions in competitive markets, Resources Policy, 23:163-171. Guj, P and Garzon, R, 2007. Modern asset pricing A valuable real option complement to discounted cash flow modelling of mining projects, in Proceedings Project Evaluation 2007, pp 113-119 (The Australasian Institute of Mining and Metallurgy: Melbourne). Hall, J and Nicholls, S, 2007. Valuation of mining projects using option pricing techniques, JASSA, 4:22-29. Kelly, S, 1998. A binomial lattice approach for valuing a mining property IPO, The Quarterly Review of Economics and Finance, 38:693. Kelly, S, 2004. The market premium for the option to close: Evidence from Australian gold mining firms, EFA Maastricht meetings paper. Kulatilaka, N and Marcus, A J, 1992. Project valuation under uncertainty: When does DCF fail? Journal of Applied Corporate Finance, 5:92-100. Kulatilaka, N and Trigeorgis, L, 1994. The general flexibility to switch: Real option revisited, The International Journal of Finance, 6:778-798. Laughton, D G, 1996. How use of a single corporate hurdle rate can undervalue low cost mines and long life mines and what to do about it: An example of modern asset pricing, in 98th Annual General Meeting of the Canadian Institute of Mining, Metallurgy and Petroleum (Canadian Institute of Mining, Metallurgy and Petroleum: Montral).

The ROV by using BOP has been calculated to be $1298 million, which is significantly greater than DCF (-$708 million). The main reason of this difference is that the following calculation could be close if the zinc price goes down and reopen when the zinc price goes up. In the following calculation, if production rate is optimised over the mine life, then ROV will increase to $1444 million. Then, the Century Mine should produce at maximum production rate. Consequently, the ROV gave a significant positive value for the project and the Century zinc mine should be opened and has flexibility to reopen and close during the mine life.

CONCLUSION
This paper compares investment in mining projects with other industrial projects, and concludes that investment in mining is partially irreversible, uncertain and may require a delay in commencement. Moreover, risk is one of the significant variables associated with mining projects over the entire mine life. The mining company manager has flexibility in the mining project to exploit the risk with the purpose of maximising the mines profit. A new version of the Brennan and Schwartz model has been introduced that adds the total cost as a function in the model. The model needs to estimate the closing cost and reopening cost for mining projects. According to cost functions, the value of mining projects is maximised via ROV. The advantage of this model is that it calculates the mine value in each period and simulates the production rate for maximising mining project value. The new model has been implemented for the Century Mine and compared NPV and ROV methods. The NPV via the ROV method and binomial option price (BOP) has been calculated to be a positive figure. This is significantly better than the NPV value obtained by the discounted cash flow (DCF) method which produced a negative result. The main reason for this difference is that the new method allows mine closure if the zinc price goes down and the option to reopen when the zinc price goes up. The new ROV model requires the estimated cost of temporary or permanent closure and reopening. This is added to the model in the event that these scenarios occur as apart of the maximisation process. As a result, the mining project would have responded in uncertainty and flexibility by closing and reopening the mine.

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