Uncertainty and real options – 2

Problem 1 (UoL preliminary exam, 2020)

Tinpot Resources (TR), an all-equity firm, is considering purchasing the rights to operate an
iron ore mine in the Pilbara region of Western Australia. Acquiring the rights will cost $50,000
today (time 0) but will also oblige TR to pay substantial environmental rehabilitation costs of
$250,000 when the mine is shut down in 3 years’ time. While in operation, the mine is
expected to produce 20,000 tonnes of iron ore per year, with extraction costs running at $93
per tonne.

Although TR knows it can sell iron ore in the market for $100 per tonne in the first year, it faces
considerable uncertainty regarding the future iron ore price, which is equally likely to rise by
10% or fall by 15% in each of the subsequent two years.

There are no taxes or any other costs. Unless otherwise stated, assume any cash flows occur
at the end of each year. Use a discount rate of 20% for all cash flows. Show your calculations.

a) Draw a binomial tree depicting the possible market prices of iron ore during the mine’s
operating life. Remember, the price in year 1 is known with certainty. What is the expected
market price of iron ore in years 2 and 3?

b) Calculate the NPV of the project. Should TR purchase the rights?

c) Explain why using the IRR rule is likely to result in an incorrect decision when evaluating this
project (do not attempt to calculate the IRR). Be specific.

Now assume that TR has the ability to temporarily halt extraction operations if iron ore prices
move adversely. However, by doing so, it cannot avoid paying the environmental
rehabilitation costs at the end of the mine’s life.

d) When will TR choose to exercise this option? Explain fully.

e) Determine the value of the abandonment option and comment on the source of the
option value.

Problem 2
CVS Health is considering entering Spanish market and estimates the net present value of this
investment to be -$250 million. If the Spanish venture does better than expected, CVS plans to
expand the network to 5 other European markets at a cost of $ 700 million. Based on its current
assessment of this market, CVS believes that the present value of the expected cash flows on
this investment is only $ 500 million. The saving grace is that the latter present value is an
estimate and CVS is not familiar with European market; a Monte Carlo simulation of the
investments yields a standard deviation of 60%. CVS will have to make the expansion decision
within 3 years of the Spanish investment, risk-free rate is 3.5%, cost of capital is 10%. Determine
the value of the option

Problem 3
A company is considering a project. The present value of the project’s cash flows is $25 mln
with annual volatility of 20%. The required initial investment is $27 mln. The projects can be
expanded in 2 years by 25% at any time with an additional investment of $5 mln. and present
value (at 0) of additional cash flows of $10 mln. Cost of capital is 12%, risk-free rate is 5%. Given
this data determine the value of the real option