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Breakout 9

Mining Asset/Extractive Industries Valuation

A New Era of Risk and Uncertainty Analysis

In Project Valuation

Presented by
Nuzulul Haq

Bali International Convention Center

27 – 30 September 2010
A New Era of Risk and Uncertainty Analysis
In Project Valuation

Commonly, business practitioners used “one size fits all” single corporate discount rate
method for valuing uncertainty in the project valuation

A new era is coming for the industry. An era where project, business or commercial analyst,
not only ask themselves the question “what if…?” when evaluating their respective project,
but also want to know what is the effect of these “what if...?” uncertainties on their project
evaluation process, as well as the best strategies to follow when facing either an adverse or
a favorable condition.

On this new approach, we can move beyond the static “now or never” decision framework
that is implicit in most current analysis to an explicit modeling and analysis, using Real
Options Analysis (ROA), to examine the effects of the contingent decision sequences that
actually occur in most business situations.

The paper shows that a project that can be produced and abandoned at will has large values
of flexibility. The conventional Net Present Value (NPV) of such a project will underestimate
the true economic value. A further benefit of using the ROA approach discussed here is that
the valuation procedure produces a strategy map showing actions within the project, not just
a number.

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The era of high uncertain of commodity price requires the economic reassessment of many
mining projects. The primary valuation challenge confronting mining appraiser is to
recognize the uncertainty during the project life and the impact these uncertainties on the
project cash flow uncertainty.

Conventional mining project valuation uses an approach called net present value (NPV)
analysis based on static discounted cash flow (DCF) method.
This method has been used since the late 1800s to value and manage mining projects. This
involves forecasting the cash flows associated with a given mine plan, discounting those
cash flows to the present using a risk-adjusted discount rate (RADR), and then summing the
resultant discounted values.

The mining industry for the most part uses the DCF valuation method to estimate asset
values because it is simple and straight away. However this method is too generalized and
could be misleading especially for valuing mining project.

There are some assumptions behind the DCF valuation method, i.e.:
1. Expected future cash flows from the project are taken as “given”. They are assumed
to be certain to happen
2. Project risk does not change throughout its life
3. The project is a “now or never” opportunity. Once the project is undertaken, it will not
be affected by any future managerial decision.

Since the last two decades, valuation professionals have been actively investigating how to
improve Discounted Cash Flow (DCF) valuation methods by better representing mining
industry complexities in their cash flow models.

They look for the valuation methods that able to:

1. compute and value non linear cash flow pay offs that accrue to project owner
2. asses the impact of the uncertain variables on the project value and risk
3. recognize managerial flexibility to intervene the project in facing either an adverse or
a favorable condition

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Real Options (RO) is considered as a modern valuation methods that able to accommodate
the above conditions. This method had been introduced to the mining industry as an
alternative to the DCF valuation methods.

This paper will use two valuation approaches (DCF and RO) to assess the impact of the
uncertainty of the commodity price on the projects value and risk. The difference in their
approach to adjusting project cash flow for risk gives the different results of the project value.

An analysis on one Coal Mine Project illustrates how valuation methods affect the
uncertainty, characteristics, and value of project cash flow streams when both discounted
cash flow (DCF) and real options (RO) methods are used to calculate net present value
(NPV) for project cash flow.

A comparison is made between the DCF and RO risk adjustments applied to each cash flow
stream to show how each method deals with the effects on value of the differences in
uncertainty of project cash flows.

In this paper, we also examine the applicability of Real Options in valuing this coal project
having operating flexibility options.

This paper is organized into the following sections: 1 – Introduction, 2 – The Issues of the
Conventional Valuation on Mining Project, 3 – The Difference between DCF and Real
Options, 4 – Case Study on Mining Project Valuation under Uncertainty, and 5 - Conclusion.


Currently, appraisers predominantly use single point forecast Net Present Value (NPV)
resulted from Discounted Cash Flow (DCF) method for their mining project valuation.

The primary limitation of cash flow models relying on single point forecasts is their inability to
compute and value non-linear cash flow pay-offs that accrue to project owner. Non-linear
cash flows have a curved dependence on the uncertain variables (like commodity price) that
are inputs into the cash flow model.

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These cash flow models are best estimated using Monte Carlo on the uncertain input
variables. Monte Carlo simulation is one of several methods of random sampling. This type
of approach is preferred because it is best able to account for high dimensional non-linearity
that arises from path dependence inherent in tax loss carry forwards and profitability triggers.

Monte Carlo simulation is used to characterize the exposures of the project owners to the
risky cash flow streams generated from the project

The other issue is related to the assumption behind the conventional NPV that assumes
cash flow uncertainty is growing over the life of the project.

A fundamental principle of valuation theory is that investors are concerned with net cash flow
uncertainty and require compensations for being exposed to risk (i.e. risk adverse). In reality,
net cash flow uncertainty can vary tremendously over the life of the project due to changes in
cost structure, price levels, uncertainty characteristics and operating strategy.

Figure 1. Profile of Net Cash Flow Discount Factor

As shown in figure 1, the conventional NPV analysis would discount project cash flow using
a constant discount rate. This is problematic since it violates the principle of investor risk
aversion where the net cash flow uncertainty is not increasing at a constant rate (Blais et all,
2006). Using this analysis, longer the project would be put on production, higher discounting
factor would be applied to the cash flow generated from the project. This would penalize the
long-lived project like in mining industry.

The other issues in conventional NPV analysis is once of investment is made, the project will
run its course without intervention (“now or never”). It‟s contrary to the real situation that

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project owner has a flexibility to intervene that project when there is new information in the

The conventional NPV based DCF looks failed to assess the impact of the uncertainty and
the effect of contingent decision when facing either the adverse or favorable condition in the


Uncertainty introduces considerable complexity into the mine planning exercise not only
because it makes the problem larger and less tractable, but also because it makes
measuring the value outcomes of the various decision alternatives more difficult.

In the first publishing of Real Options (RO), it is an alternative method for project valuation
that can accommodate managerial flexibility in adapting and revising future decisions in
response to changing circumstances.

Figure 2, Conventional NPV vs. Real Options

As shown in figure 2, this method is mainly based on the flexibility of the project. The more
flexible the project is, the more valuable it is, because it allows the owner to respond to
future events in ways that will increase the value of the firm. Option valuation gives extra
value to the project because of the flexibility.
The NPV resulted from Real Options method is known as Expanded NPV, where the formula
is as follows:
1) Expanded NPV = NPV + Option Value

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However, in the recent development of Real Options method, there is a fundamental
difference between DCF and RO methods although there is no flexibility in the project. This
new concept of real options rose up after publishing a series of papers in 1998 discussing
modern asset pricing methods for upstream petroleum project (Laughton, 1998).

DCF (net cash flow) Real Options (at source)

Commodity Price Risk Adjustment

(Source of Uncertainty)

Project Financial Model

Project Net Cash Flow

Risk Adjusted Rate Risk Free Rate

Project Value

Figure 3. DCF vs RO (modified from Samis et all, 2006)

Assuming the main source of the uncertainty of the project is the commodity price, figure 3
shows that in the absence of managerial flexibility, the first step in RO valuation is to apply
risk discount factor to each uncertain cash flow element arising in any one period.

The difference in risk adjustment between the DCF and RO valuation methods appears to be
nuanced but its consequences are potentially large. This process allows senior management
to use financial market information to determine the underlying structure of risk adjustments
for the uncertain variables of interest to the corporation. The detailed project cash flow
dependence on these underlying uncertain variables then determines how these underlying
risk adjustments are transformed implicitly into risk discounts for the project cash flow.

Risk discounting the project cash flows in this way ground the valuation in the financial
markets of relevance to investors. It also tunes the risk discounting in a controllable way to
the types and amounts of risk actually in the project cash flows, as opposed to using some
average discounting that it is not likely to be appropriate for the risk involved.

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All of this rids the valuation process of some biases that are inherent in the DCF method,
which assumes that all projects and claims against those projects have the same structure of
risk. In the mining industry, these biases include a general bias against investment to reduce
future costs, a bias against mine plan designs with long-term production profiles, and, finally,
a bias against projects that face taxes, that are geared toward taking disproportionately more
revenue in realizations of the future characterized by high output prices.

The difference between DCF and RO methods of adjusting for cash flow risk when
calculating a cash flow NPV can be illustrated using the concept of Net Cash Flow Risk
Discount Factors (NCFRDFs). A NCFRDF calculates the magnitude of risk adjustment that
is applied to each dollar of a cash flow in a particular year. It indicates the amount an
investor will pay for a dollar of cash flow from a particular cash flow stream on a risk adjusted
(but not time adjusted) basis.

A NCFRDF is defined as the present value of a cash flow divided by the expected cash flow
after offsetting the adjustment for the time value of money:
2) NCFRDFt 
( ECFt * TDFt )

CFPV = the cash flow present value at project time „t‟
ECF = expected cash flow at project time „t‟
TDF = time discount factor at project time „t‟ = 1/(1 + risk free rate)t

RO and DCF have different NCFRDF equations because their respective approaches to risk
discounting differ.
A simple DCF NCFRDF for project owner at time „t‟ can be calculated as follows:
( Mineprod t * Cmdtyprice  OpCostt ) * RDFt , DCF * TDFt
3) NCFRDFt, DCF, Project Owner   RDFt , DCF
( Mineprod t * Cmdtyprice t  OpCostt ) * TDFt

Mineprod = Mine production
Cmdtyprice = expected commodity price
OpCost = expected operating costs
RDFDCF = DCF risk discount factor = 1/(1+risk premium)t

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The numerator is the present value of the cash flow as calculated using the DCF method.
The product RDFDCF * TDF is an approximate representation of the conventional discrete
DCF discounting formula that combines the risk and time adjustment into one discount rate.
The TDF in the denominator offsets the effects of time discounting so that we can examine
only the discounting for risk.

Equation 3 shows that project structure does not affect DCF risk discounting since the cash
flow equations in the numerator and denominator cancel each other. However, project
structure is very much part of the RO risk discounting mechanics.

The simple RO NCFRDF for project owner at time „t‟ can be calculated as follows:
(( Mineprod t * Cmdtyprice * RDFt ,cmdty ) * TDFt  PVOpCost t )
NCFRDFt, RO, Project Owner 
4) ( Mineprod t * Cmdtyprice t  OpCostt ) * TDFt
(( Mineprod t * Cmdtyprice * RDFt ,cmdty )  PVOpCost t / TDFt )

( Mineprod t * Cmdtyprice t  OpCostt )
PVOpCost = PV of expected operating costs
RDFCmdty = a market-based risk adjustment for pure commodity
price uncertainty

In the first line of this derivation the numerator is the present value of the cash flow
calculated using the real option method. The commodity risk adjustments in the RO method
are calculated using formulas that are consistent with the Capital Asset Pricing Model and
are able to recognize commodity price uncertainty. Salahor (1998) provides details of these
risk adjustment formulas.

Equation 4 shows that the cash flow equations cannot be factored out of the value
calculation because RO applies a market-based risk adjustment to the source of uncertainty
and then filters its effect through to the net cash flow stream. The application of a risk-
adjustment to the source of uncertainty results in the effective net cash flow risk adjustment
generated by RO recognizing changes in cash flow uncertainty as operating leverage varies.

Based on the above explanation, basically both DCF and RO has similar mechanism in
modeling future technical and commercial variables within a project, also they can be applied
to model likely managerial reactions to that uncertainty.

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However, although real options is also used a discounted cash flow technique, it differs from
DCF method in two important ways i.e.:
1. real options uses market information to discount for the risk in the project cash flow to
recognize the unique risk profile of the projects
2. real options analysis puts particular emphasis on dynamic decision making, the “now
or later” alternative.

In essence, real options values the asset while at the same time anticipating how the asset
will be optimally managed, conditional on the market information and options available to the
manager in each decision period (Davis, 2008).


In this section, a coal mine project is selected to carry out the reality investigations. This coal
project is valued using the following approach:

1. DCF vs. Real Options without early closure options (ignore managerial flexibility)
2. DCF vs. Real Options with early closure options (consider managerial flexibility)

In this case study, we assumed the main source of the uncertainty of the project is the coal
price (S) that will follow a one factor Geometric Brownian Motion (GBM):
5)  α dt  σ dz
dS = coal price different
 = short term price volatility (%, annualized)
α = short term expected price growth (%, annualized)
dz = an increment of standard winner process
dt = time different

Based on the above price model, coal price uncertainty will increase over the life of the

The technical and commercial data of the coal project is shown in the table 1.

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Parameter Descriptions
Technical Data
Mineable reserve (million ton) 303.7
Stripping ratio 1:8
Mine life (years) 7
Average Production plan (ton/year) 17.8
Commercial Data
Spot price ($/ton) 60
Long term price forecast ($/ton) 60
Operating Cost ($/ton) 28
Capex ($ millions) 179.2
Closure Cost ($/ton) of the coal produced 0.1
Royalty 13.5%
Income Tax 41.75%
Risk adjusted discount rate 15%
Risk free discount rate 5%

Table 1. Technical and Commercial Data of Coal Project

Since mining is a massive industry, the projects in this industry would potentially damage the
environment. Therefore, the company is obliged to conduct mine reclamation after
completed the project. The cost related to this activity is known as closure cost.
Mining appraisers should recognize the impact the closure cost on the cash flow uncertainty
in their project valuation.

In this case, we investigate how DCF and RO method recognize the unique risk profile of
closure cost spending in the end of the project.

4.1 DCF vs. Real Options without options (ignore managerial flexibility)

In this section, we would analyze how DCF and RO methods affect the uncertainty
characteristics and value of project cash flow stream. We assume management would not
intervene the project in the future.

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Coal price (US$/ton) 250





0 2 4 6 8 10 12 14 16 18
Project time (years)
Coal price Risk-adjusted Coal price Upper confidence bdy

Lower confidence bdy Long Term Equilibrium Price

Figure 4 - Forward Price Model

The uncertainty characteristics of project cash flow over the life of the project were modeled
with Monte Carlo simulation using the coal price models displayed in figure 4.

To quantify the uncertainty, we use a coefficient of variation (CoV) that was recorded
annually for each cash flow. The coefficient of variation is the standard deviation of an
uncertain variable divided by its expected value, providing an indication of cash flow
dispersion (the higher the number the greater the uncertainty). It is used to highlight the level
of uncertainty in project cash flow stream.
Closure Cost
Cash flow uncertainty (% deviation)


High capital



0 2 4 6 8 10 12 14 16 18
Project time (year)

Figure 5 - Coefficients of variation for project owner‟s cash flow stream

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Calculating values for the project cash flow streams in a manner consistent with the principle
of investor risk aversion is difficult because the uncertainty characteristics of cash flow
stream vary markedly. This task is further complicated because cash flow uncertainty for
project may vary by year as production rates, costs structures and capital depreciation
balances fluctuate.

Figure 5 presents the various cash flow stream CoVs during production operations. The solid
black line delineates the CoVs for the project cash flows as uncertainty of coal price
increase. The increase of deviation percentage in Year 3 and 4 is caused by high capital
expenditure in that period. The profile of project cash flow CoVs indicates that project cash
flow uncertainty varies in the year 1 to year 5 of the project and going increase after Year 5.
This is caused by the volatility tend to increase and profit margin decrease due to decrease

In the end the project, there is a spike of cash flow uncertainty. This is due to cost spending
for mine closure.

250% 1.0

200% 0.8
Net cash flow discount factor
Cash flow deviation (%)

150% 0.6

100% 0.4

50% 0.2

0% 0.0
0 2 4 6 8 10 12 14 16 18
Project time (year)

Project CF deviation DCF NCFDF RO NCFDF

Figure 6 - Project owner cash flow DCF and Real Options NCFRDFs

Figures 6 compare the DCF and RO risk adjustments applied to the various project cash
flow streams and links these adjustments to levels of cash flow uncertainty during each year.

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In each of these graphs the vertical axis on the left side represents the level of cash flow
uncertainty. These are plotted with a solid black line, taken from Figures 5. The vertical axis
on the right side represents the NCFRDFs. The DCF and RO NCFRDFs are plotted with
grey lines; the dashed line with no data markers delineates the DCF NCFRDF and the lines
with data markers outline the RO NCFRDFs.

The difference between 1.00 and the NCFRDF is the amount of compensation an investor
requires for exposure to uncertainty in project cash flow stream.
The project cash flow uncertainty and risk discounting is provided in Figure 6. Cash flow
uncertainty increases with time as production decline and coal price uncertainty increases.
There is a jump in Year 3 and 4 due to higher capital spending in that period.

The RO NCFRDFs show that the effective project cash flow risk discounting reflects the
cash flow uncertainty. For example, in Year 4 (red circle in figure 6), the risk discount
decreases to $0.45 per dollar of cash flow (i.e. $1 cash flow is worth $0.55 on a risk-adjusted
but not time discounted basis).

Conversely, the DCF NCFRDF reflects a risk adjustment that is increasing over time. This
highlights a DCF assumption that cash flow uncertainty is growing over the life of the project.
The project CoVs show that project cash flow uncertainty in fact rises and falls throughout
the project horizon.

High cash flow risk in the end of the project is described in RO NCFRDFs by applying higher
risk discounting factor than in DCF NCFRDFs.

Static Monte Carlo

Cumulative expected net cash flows ($ thousands)
Project Level 4,047,079 6,659,029
Expected time-discounted stakeholder cash flows ($ thousands)
Project Level 2,680,505 4,212,416
Type of Risk discounting DCF RO
Static Monte Carlo Static Monte Carlo
Expected stakeholder cash flow NPV ($ thousands)
Project Level 1,401,328 2,030,366 1,292,735 2,194,521

Table 2. Cash Flow Summary

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The valuation result for the coal project is presented in Table 2. The following cash flows and
Net Present Value (NPV) were calculated for project using both a conventional single-point
forecast cash flow model („Static‟) and a Monte Carlo simulation model:
1. Cumulative expected net cash flow,
2. Time-adjusted cumulative expected net cash flow where discounting is performed at
the risk-free rate of five percent,
3. A DCF NPV calculated using an fifteen per cent discount rate, and
4. A RO NPV calculated with risk-adjusted expected coal price and the risk-free rate of
five percent.

The project in table 2 has an expected cumulative cash flow of US$ 4,047 million using a
spreadsheet model. The Monte Carlo analysis estimates the different value for project
cumulative cash flow of US$ 6,659 million. The difference occurred because as is typical, the
static method underestimates the upside potential value of the project.

US$ 4,047 million cash flow received from project has a present value of US$ 1,401 million
using DCF method with a fifteen per cent discount rate, and the US$ 6,659 million project
cash flow estimated using Monte Carlo analysis has a value of US$ 2,030 million when
discounted at a fifteen per cent discount rate. The difference is true whether Static
spreadsheet or Monte Carlo analysis is used because there are non-linearities in the cash

None of these values is likely to be correct. However, it is well-recognized that cash flows
that are more sensitive to price variability should be discounted at a higher rate.
Looking back to Figure 5, it is unreasonable to discount the project cash flow in Year 4 at
fifteen per cent, and then discount the project cash flow in Year 5, which has much lower
variability, at the same fifteen per cent. RO valuation methods take this varying cash flow
uncertainty across time and across cash flow type into account.

Under the RO Monte Carlo approach and ignore managerial flexibility, which uses market
information and formal models of risk discounting to estimate appropriate cash flow risk
discounting, the project has a value of US 2,195 million.

Figure 6 also provides an explanation for RO Monte Carlo calculating a higher project NPV
than the DCF Monte Carlo method in Tables 2. On average, the RO method applies a lower

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risk adjustment to each dollar of project cash flow than the DCF method because it is picking
up coal price uncertainty and the high correlation between coal price and financial market
uncertainty in its risk adjustments. It is indicated that the DCF discount rate of fifteen per
cent was too high for this project.

4.2 DCF vs. Real Options with early closure options (consider managerial flexibility)

In this section, the applicability DCF and RO method to consider managerial flexibility will be
investigated. Using the previous case study, we extend the case by assuming management
has an ability to close the coal project at any time is incorporated into the project model. An
early closure option is included in DCF and RO methods since managers have the ability to
permanently exit this coal project when coal price turn unfavorable.

There are two options available for management, i.e.:

1. Management can close the coal project early by spending closure cost if coal price is
lower than cash cost
2. Management can keep continue the production if the coal price is still higher than
cash cost.

Type of Risk discounting DCF RO

No Flexibility Flexibility No Flexibility Flexibility
Equity Level Include Financing 2,030,366 2,079,042 2,194,521 2,552,922
Option Value 48,675 358,400

Table 3. Comparison Result

As shown in table 3, under DCF method, if we consider the managerial flexibility in the
project, the ability to limit downside risk with an early closure option increases project value
by an estimated over $48.7 million, producing a total estimated project value of $2,079

However, under RO method, there is a significant increase of the project value if we consider
early closure option by an estimated over $358.4 million, producing a total estimated project
value of $2,553 million.

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Based on this study, the potential value of this coal project would be $2,553 million under
RO valuation method with early closure option.

The results highlight that ignoring managerial flexibility such as early closure option can
generate misleading project value estimates. Managers often have the ability to manage
project risk with operational strategies and this ability can have significantly effect on project


The era of high uncertain of commodity price requires the economic reassessment of many
mining projects. The primary valuation challenge confronting mining appraisers is to
recognize the uncertainty during the project life and the impact these uncertainties on the
project cash flow uncertainty.

This paper investigated the impact of commodity price uncertainty on the cash flows of a
mining project using Monte Carlo simulation. The results show that a conventional cash flow
model using single-point input values may contain important cash flow estimation errors.

The single point forecast can give incorrect result when such non linearity exist in project
cash flow. These errors are corrected in a Monte Carlo analysis.

Monte Carlo simulation corrected these errors by recognizing cash flow non-linearities in the
cash flow stream. Taxes not only introduce complicated non-linearities into the valuation
process, but they also alter the riskiness of the cash flows received by project owner. DCF
method discounts all cash flow streams at the same rate. Real Options method brings this
out, with logically higher discounting of riskier cash flow streams and lower discounting of
less risky cash flow streams.

We have described the concept of Real Options method combined with Monte Carlo
simulation as an alternative method to the DCF method in valuing the mine project.

We have also described how managerial flexibility can be included in both of DCF and RO
method to improve the assessment of project value.

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The result shows that improper risk assessment on cash flow uncertainty properly and
ignoring managerial flexibility can generate misleading project value estimates.

The results reported in this paper are preliminary, pending a careful statistical examination of
the robustness of the valuation procedure. However, this paper concludes that the Real
Options can be applied in mining project valuation. The RO method is more likely to reveal a
true picture of the value of the mining projects.


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