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Valuing Real Capital

Investments Using The Least-
Squares Monte Carlo Method
a b
Sabry A. Abdel Sabour & Richard Poulin
a
Mining & Metallurgical Engineering Department ,
Assiut University , Egypt
b
Département de génie des mines, de la
métallurgie et des matériaux , Universite Laval,
(Québec) , Québec, Canada
Published online: 21 Sep 2006.

To cite this article: Sabry A. Abdel Sabour & Richard Poulin (2006) Valuing Real
Capital Investments Using The Least-Squares Monte Carlo Method, The Engineering
Economist: A Journal Devoted to the Problems of Capital Investment, 51:2, 141-160

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 The Engineering Economist, 51: 141–160
Copyright © 2006 Institute of Industrial Engineers
ISSN: 0013-791X print / 1547-2701 online
DOI: 10.1080/00137910600705210

VALUING REAL CAPITAL INVESTMENTS USING

THE LEAST-SQUARES MONTE CARLO METHOD

Sabry A. Abdel Sabour

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Mining & Metallurgical Engineering Department, Assiut University, Egypt

Richard Poulin

Département de génie des mines, de la métallurgie et des matériaux,

Universite Laval, Québec (Québec), Canada

The recently developed least-squares Monte Carlo (LSM) method provides

a simple and efficient technique for valuing American-type options. The
proposed method is applicable to the cases of compound real options, like
the other numerical techniques such as finite difference and lattice meth-
ods, with the additional advantage to handle easily the cases of multiple
uncertain state variables with different and complex stochastic processes.
With this advantage, the LSM method is not only efficient for valuing
multi-factor American options, but it can also be extended for valuing com-
plex real investments having many embedded real options and involving
multiple uncertain state variables. This article examines the applicability
of the LSM method in valuing real capital investments. Two valuation
examples have been provided to test the efficiency of the proposed method
in both the valuation and the decision-making processes.

INTRODUCTION

Among the traditional methods of investment appraisal, the most widely

used one is the discounted cash flow net present value (NPV). In addition
to the problem of forecasting and discounting future cash flows, the impor-
tant drawback of the NPV method is that it cannot deal with the issue of

Address correspondence to Richard Poulin, Université Laval, Pavillon Adrien–Pouliot,

G1K 7P4, Québec (Québec), Canada. E-mail: Richard.Poulin@vrex.ulaval.ca, richard.poulin@
fsg.ulaval.ca
 142 S.A.A. Sabour and R. Poulin

management flexibility. The decision rule of the NPV is to undertake the

investments with positive net present values and reject those with negative
net present values. By this immediate accept/reject decision, the NPV ig-
nores the value of the real options embedded in capital investments such
as the option to defer the investment, the option to expand capacity, the op-
tion to contract, the option to shut down, and the option to abandon for the
salvage value. Since the market conditions are highly uncertain, these flex-
ibility options can add a significant value to the underlying project. There-
fore, as explained by many researchers (see, for example, refs. Feinstein
and Lander (2002); Keswani and Shackleton (2006); Moyen et al. (1996)
for more explanations), the NPV method underestimates capital invest-
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ments. The failure to address the management responses to the cyclic price
movements will result in inaccurate estimates and consequently will lead
to wrong decisions.
Unlike the NPV method, the real options approach (ROA) can deal effi-
ciently with the issue of management flexibility to alter or revise decisions
when the uncertainty about some key variables is resolved. As explained by
Miller and Park (2002), while the discounted cash flow analysis is applica-
ble only to projects with low payoff volatility, the ROA is applicable to most
projects due to its efficiency to handle the high volatility that characterizes
the real investment projects. The growing list of ROA applications includes:
R&D industries, technology investments, natural resource industries, and
manufacturing and inventory projects (see Trigeorgis (1996); Miller and
Park (2002) for more details and references).
The methods for valuing options can be divided into analytical and
numerical methods. The first analytic model for valuing simple financial
options was developed by Black and Scholes (1973). Following Black
and Scholes, the research has been directed to develop numerical methods
capable to deal with the issue of valuing complex options such as the
American-type options with multiple uncertain state variables.
The most widely known numerical techniques for valuing options are:
finite difference (see Shwartz (1977); Brennan and Schwartz (1977, 1978),
binomial lattice (see Cox et al. (1979)), and Monte Carlo simulation (de-
veloped by Boyle (1977)). The most important drawback of both finite
difference and lattice methods is that they are impractical for valuing com-
plex options with multiple uncertain state variables. As explained by Grant
et al. (1997), both finite difference and lattice methods can only be applied
for valuing options with a few uncertain state variables. Also, Barraquand
and Martineau (1995) argued that both finite difference and binomial lat-
tice methods suffer the curse of dimensionality when applied for valuing
options with more than two assets since the level of complexity grows
exponentially with the number of underlying assets. In contrast to both
the finite difference and lattice methods, Monte Carlo simulation can deal
 Valuing Real Capital Investments 143

efficiently with the situations where there are multiple and complex stochas-
tic variables. In the Monte Carlo method, the value of an option is deter-
mined by simulating sample paths for the stock price, determining the
option payoff in each path, and then discounting at the risk-free rate and
averaging by the number of simulated paths.
Until recently, there was a general belief that since Monte Carlo simula-
tion is a forward induction technique, it cannot deal with the early exercise
feature of American options and accordingly it is applicable only for valu-
ing European options (Hull and White, 1993). Tilley (1993) was the first
researcher to propose a modification to Monte Carlo simulation in order to
make it applicable for valuing American options. As explained by Boyle
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et al. (1997), the main drawbacks of Tilley’s algorithm are that the estima-
tor tends to be biased high and it is difficult to apply it for valuing options
with multiple state variables. To overcome this problem, Barraquand and
Martineau (1995) proposed the stratified state aggregation in which the op-
tion payoff space is partitioned instead of the stock price space. Although
Barraquand and Martineau’s approach can value American securities with
multiple state variables, it tends to undervalue options since its exercise pol-
icy is not the optimal one (Boyle et al., 1997). Carriere (1996) provided a
sequential regression algorithm in which the optimal early exercise policy
is determined by estimating the conditional expectations using nonpara-
metric regression techniques. Compared to Tilley’s algorithm, the method
proposed by Carriere is less biased, but there is also a debate about its
applicability to value multi-factor American options.
In an attempt to reduce the bias and extend Monte Carlo simulation
method to the cases where there are multiple state variables, Broadie
and Glasserman (1997) proposed a different simulation algorithm that
combines the Monte Carlo method with the decision-tree technique. As
demonstrated by Grant et al. (1997), the main drawback of Broadie and
Glasserman’s algorithm is that because the quantity of data increases ex-
ponentially with the number of early exercise dates, it is impractical for
applications that require dividing the time to maturity into a large number
of early exercise dates. Longstaff and Schwartz (2001) proposed a simple
method for valuing American options using Monte Carlo simulation based
on least-squares method. The advantages of the proposed least-squares
Monte Carlo (LSM) method over the other proposed simulation techniques
are that it is simple, requires less computational time, and can be applied to
value complex options with many underlying stochastic variables. Tsitsiklis
and Van Roy (2001) proposed a similar regression-based method for valu-
ing American-style options using simulation. Different from the method
proposed by Longstaff and Schwartz (2001), the method is based on approx-
imating the value function directly using a linear combination of known
basis functions.
 144 S.A.A. Sabour and R. Poulin

In most real investment projects, with the operating flexibility to switch

among different operating modes in response to the cyclic market move-
ments, the project cash flows are path-dependent. When the project includes
only one source of uncertainty, this management flexibility can be easily
dealt with using the widely known techniques for valuing real options
such as finite difference and binomial lattice methods. For more complex
projects, where there are many uncertain state variables affecting the project
value, the valuation process becomes more and more complex. In such
cases, the valuator has to deal with the uncertainty of many state variables
simultaneously with different and complex stochastic processes while con-
ducting the real options valuation. To make the real options approach more
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practical and easy to be applied in the regular strategic decisions, there is

a need for a more efficient and simple real options valuation technique. It
seems that the LSM method is the most efficient candidate to handle such
complex problems. Fortunately, the proposed LSM method combines the
simplicity of simulation techniques with the ability to deal easily with mul-
tiple uncertain state variables. With this specification, the LSM method is
not only efficient for valuing multi-factor American options, but it can also
be extended for valuing real capital investments having many embedded
management flexibilities and involving multiple uncertain state variables.
In this article, we examine the applicability of the LSM method in valuing
real investment projects having compound flexibility options. In the next
section we briefly explain the mechanism of the LSM method developed
by Longstaff and Schwartz (2001) for valuing American options. Then,
we use the valuation results of previously published work to examine the
accuracy of the LSM method as a valuation and as a decision-making tool
and compare our valuation results with the valuation results of the other
work. Finally, we extend the LSM method for valuing a capital investment
project with seven uncertain state variables.

THE LSM METHOD

The LSM method proposed by Longstaff and Schwartz (2001) is based on

the assumption that American options can be exercised at discrete early
exercise dates. The time to maturity T is divided into K discrete times
(0 < t1 ≤ t2 ≤ . . . ≤ tK = T) and N simulated paths are generated under
the risk-neutral measure. The LSM method accurately approximates the
value of American options when K is very large. The valuation starts at the
final expiration date tK = T and proceeds backward. The put option payoff
C(w; tk = T) at the expiration date along the sample path w is

C(w; t K = T ) = max[(H − S(w, T )), 0] (1)

 Valuing Real Capital Investments 145

where H is the exercise price of the put option and S(w,T) is the stock price
at maturity along the path w.
At any early exercise time tk < T, if the option is in the money, the
optimal exercise policy is determined by comparing the immediate exercise
payoff with the expected continuation value. The immediate exercise value
along the path w is simply the difference between the exercise price H
and the stock price S(w,tk ). Under the risk-neutral pricing measure Q, the
expected continuation value F(w;tk ) based on the information β at time tk
assuming that the option is not exercised until after tk and the option holder
following the optimal stopping strategy for all x, tk < x ≤ T is
  tj  

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 K 
F(w; tk ) = E Q  exp − r (w, x)d x  C(w, t j ; tk , T ) βtk  (2)
j=k+1
tk

where C(w,tj ;tk ,T) is the remaining cash flows and r(w,x) is the risk-free
discount rate.
The least-squares regression is applied to estimate the conditional expec-
tation function at tK−1 , tK−2 , . . . , t1 assuming that the unknown functional
form of F(w;tk ) can be approximated by a linear combination of M ba-
sis functions Lj (S) such as Laguerre polynomials, trigonometric series, or
simple powers of the stock price S such as

M
F(w; tk ) = a j L j (S) (3)
j=0

The coefficients aj are determined using a least-squares approach by

regressing the discounted continuation values for the in-the-money paths
at time tk onto the basis functions. After estimating the conditional ex-
pectation function, the continuation value F̂M (w; tk ) at time tk along the
path w can be estimated. Comparing the immediate exercise value with
the estimated continuation value F̂M (w; tk ) at time tk , the optimal exercise
decision can be reached and the cash flows along the path w from time tk
to time T are revised. If the immediate exercise value is greater than or
equals F̂M (w; tk ), then the cash flow at tk equals H − S(w;tk ) and the subse-
quent cash flows along the same path are set to zero. If F̂M (w; tk ) is greater
than H − S(w;tk ), the cash flow at tk is zero and the remaining cash flows
along the same path are left unchanged. This procedure is repeated for the
all in-the-money paths at time tk . For the out-of-the-money paths, the early
exercise decision is irrelevant and the option payoff is zero. The recursion
proceeds backward until time t1 , determining the optimal exercise policy
and revising the remaining cash flows along the paths. After the exercise
 146 S.A.A. Sabour and R. Poulin

decisions at each exercise date along all the paths are determined, the value
of the option is estimated by discounting the cash flows to time 0 at the
risk-free rate and averaging over the number of paths N.
Although Monte Carlo simulation method is easy to implement and can
handle complex stochastic processes, its main disadvantage is the vari-
ance of the estimate. However, as explained by Boyle et al. (1997), using
the variance reduction techniques, such as the control variate, the anti-
thetic variate, moment matching, importance sampling, conditional Monte
Carlo, low-discrepancy sequences, and quasi-random sequences, can sub-
stantially reduce the variance of the estimate. Also, Moreni (2004) proposed
a variance reduction technique based on importance sampling by means of
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Girsanov theorem to increase the precision of the LSM method developed

by Longstaff and Schwartz (2001).

EXAMPLE FOR THE POSSIBLE EXTENSIONS: VALUING

NATURAL RESOURCE INVESTMENTS

In this section we investigate the possibility of extending the LSM method

to value real capital investments. As an example for the possible extensions
of the method, it will be extended to value natural resource investments. For
valuing mineral-extraction projects using the LSM method, it is assumed
that the managers will revise the project status K times per year, so that
the time step t equals 1/K. Based on the risk-adjusted stochastic process
of the metal price under study, N sample paths defining the metal price
are simulated at each time step. Then, the cash flows at each time step
throughout all the simulated paths are defined based on the metal price,
the unit production cost, and the taxes and royalty rates. At each decision
date, the managers will optimally choose to keep the mine open (closed),
change the mine status (open/close the mine), and in this case will incur
the switching costs or abandon the mine. The optimal switching policy
is determined based on the expected value of the mine when it is open
and when it is closed. The values of the open and the closed mine are
estimated conditional on the metal price S at each decision date using the
cross-information in the simulated metal price paths.
To illustrate how the optimal switching policy is determined using the
LSM method, let Vo denote the value of the mine in the open mode, Vc the
value of the mine in the closing mode, and Va the value of the abandoned
mine (equals the abandonment costs). According to the LSM method, the
unknown functional forms of Vo and Vc are approximated by a linear
combination of known basis functions whose coefficients are estimated
using least-squares regression, as explained in the previous section. After
estimating the coefficients of the basis functions, the expected values of
 Valuing Real Capital Investments 147

the mine when it is open (V̂o ) and when it is closed (V̂c ) can be estimated
conditional on the simulated metal price S at each path. The optimum
operating mode at each time step is determined by comparing the expected
values of the mine in the three operating modes. If V̂o is less than V̂c minus
the shutting cost (Cc ), the mine should be closed. If V̂c is less than V̂o
minus the reopening cost (Co ), the mine should be reopened. Otherwise, if
the value of the mine in the current mode is less than the abandonment cost,
the mine is abandoned. According to this dynamic process, the value of the
mine in the open mode is the maximum of; V̂o , V̂c − Cc , and Va , and the
value of the mine in the shutting mode is the maximum of; V̂c , V̂o − Co , and
Va . After determining the optimum operating modes and the corresponding
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revised cash flows at each time step throughout all the paths, the mine
value is estimated by discounting the cash flows at the risk-free rate and
averaging over the number of paths. A Matlab-based program is developed
by the authors for conducting the mine valuation using the LSM method.

Valuation of a Copper Mine

In this section, the accuracy of the LSM method will be tested by comparing
its valuation results for a hypothetical copper property with the valuation
results generated by finite difference technique. Table 1 shows the given
data for the hypothetical copper mine as presented in Brennan and Schwartz
(1985).
Based on the data given in Table 1, the 150 million pounds inventory
(Q) are sufficient for 15 production years at an annual rate (q) of 10 million

Table 1. Given data for a hypothetical copper mine (Brennan and Schwartz,
1985)
Item Description Item Description

Mine: Copper: price

Output rate, q 10 million Convenience yield, δ 1.0%/year
pounds/year
Inventory, Q 150 million Price variance, σ2 8.0%/year
pounds
Initial average cost of $0.5/lb Taxes:
production, a
Initial cost of opening and $200,000 Real estate, t3 2%/year
closing, Co and Cc
Initial maintenance costs, Cm $500,000/year Income, t2 50.0%
Cost inflation rate: 8%/year Royalty, t1 0%
Interest rate, r: 10%/year
 148 S.A.A. Sabour and R. Poulin

pounds. Assuming full loss offset, as in Brennan and Schwartz (1985), the
annual cash flow components are estimated as follows:

Revenue = qS
Operating costs = qa
Royalty = t1 qS
Income taxes = t2 q[S(1-t1 )-a]
Net cash flow = Revenue − Operating costs − Royalty − Income taxes

The real state tax rate (t3 ) represents the property tax rate on the value of
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the mine. With the flexibility model of Brennan and Schwartz (1985), the
management has the option to optimally revise the mine status according
to the copper price level. With this flexibility, the management can close
the mine temporarily in response to the low copper price level. In this case,
a $0.2m closing cost (Cc ) will be incurred and an annual maintenance cost
(Cm ) of $0.5m will be spent for maintaining the mine during the closing
period. If the copper prices are increased enough, the management will
be able to reopen the temporarily closed mine at a reopening cost (Co ) of
$0.2m. Otherwise, it has the option to abandon the mine at no cost (Va = 0).
As assumed by Brennan and Schwartz (1985), the copper price S evolves
according to the following geometric Brownian motion:

dS
= αdt + σ dz (4)
S

where α is the price trend, σ is the standard deviation, and dz is the incre-
ment to a standard Gauss-Wiener process. We restricted ourselves to the
simple model of Equation (4) in order to be able to compare our results
with those of Brennan and Schwartz (1985). However, the LSM method
can handle more complex stochastic processes such as the two-factor and
the three-factor models developed by Schwartz (1997). Under the risk-
neutral measure, the spot price evolves according to the following contin-
uous stochastic process

d S = (r − δ)Sdt + σ Sdz (5)

where r is the risk-free interest rate and δ is the convenience yield. Based
on the data presented in Table 1, the values of r, δ, and σ are 10%, 1%,
and 28.28% per year, respectively. The reported value of r represents the
nominal risk-free rate. Based on a cost inflation rate of 8% per year, the
real value of r is 2% per year. Samples of future prices after a short time
 Valuing Real Capital Investments 149

Table 2. Simulation and regression parameters of the copper mine example

Item Description

Number of time steps per year 10

Number of simulations 50,000
Regressors A constant and the first three terms of Laguerre polynomials
Variance reduction technique The moment matching method

t can be generated as follows:



σ2 √
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S(t + t) = S(t) exp r − δ − t + σ ω t (6)

2

where is a random number drawn each time from a normal distribution

with zero mean and variance 1.
The details of our implementation of the LSM method to value the copper
mine are given in Table 2. Table 3 lists our valuation results using the LSM
method and the finite difference valuation results of Brennan and Schwartz.
The negligible difference between the two sets of valuation results at the
different initial copper prices implies that the LSM method can accurately
value resource-extraction projects having compound flexibility options. As
shown in Table 3, it is optimal to close the open mine if the copper price is
between $0.4/lb and $0.5/lb, while it is optimal to reopen the closed mine
if the copper price is between $0.7/lb and $0.8/lb. More definitely, carrying
out the valuation process at a price interval of 0.01, the switching prices
have been found to be $0.47/lb and $0.74/lb to shut down and reopen the

Table 3. The valuation results of the copper mine

Mine value, $m
Initial
copper Our extended Brennan and Tsekrekos
price ($/lb) LSM method Schwartz [7] Cortazar [10] et al. [25]

Open Closed Open Closed Open Closed Open Closed

0.3 1.238* 1.438 1.25* 1.45 — — — —
0.4 4.134* 4.334 4.15* 4.35 4.19* 4.39 4.17* 4.37
0.5 8.012 8.181 7.95 8.11 7.97* 8.17 7.93 8.06
0.6 12.561 12.560 12.52 12.49 12.53 12.53 12.48 12.49
0.7 17.612 17.431 17.56 17.38 17.57 17.37** 17.59 17.42
0.8 22.933 22.733** 22.88 22.68** 22.90 22.70** 22.81 22.63
0.9 28.435 28.235** 28.38 28.18** 28.44 28.24** 28.31 28.11**
1.0 34.058 33.858** 34.01 33.81** 34.10 33.90** 33.92 33.73

*Optimal to close, **Optimal to open.

 150 S.A.A. Sabour and R. Poulin

mine, respectively. These critical prices are very close to those of $0.44/lb
and $0.76/lb for closing and reopening the mine obtained by Brennan and
Schwartz (1985). This similarity indicates that the LSM is an accurate
technique for determining the optimum mine status.

Comparison with the Other Work

In this section we compare the results of our work in extending the LSM
method to value natural resource investments with the other attempts car-
ried out in the same topic. Based on our knowledge, there are three previ-
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ous attempts to apply Monte Carlo simulation for valuing natural resource
projects. The first attempt was carried out by Cortázar (2001) using a differ-
ent approach, based on the algorithm of Barraquand and Martineau (1995),
to value the same copper mine presented in Brennan and Schwartz (1985)
and to determine the optimal switching policy. The valuation results of
Cortazar are listed in Table 3. Comparing the valuation results in Table 3
and the threshold copper prices for changing the mine status, it is clear that
although the approach applied by Cortazar has generated accurate valua-
tion results, it failed to determine the accurate optimal switching policy.
As shown in Table 4, the difference between the values of the open and
the closed mine equals $0.2m (the reopening cost) when the initial copper
price is $0.7/lb or higher, which indicates that the threshold copper price to
reopen the closed mine is between $0.6/lb and $0.7/lb. On the other hand,
when the initial copper price is less than or equals $0.5/lb, the value of
the closed mine exceeds that of the open mine by $0.2m (the closing cost)
which indicates that the threshold price to close the mine is between $0.5/lb

Table 4. Decision making for the copper mine

Difference between the values of the open and the closed modes, $m

Initial copper Our extended Brennan and Tsekrekos

price $/lb LSM method Schwartz (1985) Cortazar (2001) et al. (2003)

0.3 −0.20* −0.20* — —

0.4 −0.20* −0.20* −0.20* −0.20*
0.5 −0.17 −0.16 −0.20* −0.13
0.6 0.00 0.03 0.00 −0.01
0.7 0.18 0.18 0.20** 0.17
0.8 0.20** 0.20** 0.20** 0.18
0.9 0.20** 0.20** 0.20** 0.20**
1.0 0.20** 0.20** 0.20** 0.19

*Optimal to close, **Optimal to open.

 Valuing Real Capital Investments 151

and $0.6/lb. These threshold prices are different from both those estimated
by Brennan and Schwartz and our extended LSM method.
The second attempt to apply the LSM method in valuing natural re-
source investments was that of Tsekrekos et al. (2003). They applied the
LSM method to value the hypothetical copper mine treated in Brennan and
Schwartz (1985). As indicated in Table 3, the valuation results of Tsekrekos
et al. are very close to those of Brennan and Schwartz and ours, but the
threshold copper price to reopen the closed mine is very confusing. Look-
ing at Table 4, the difference between the value of the open and the closed
mine in Tsekrekos et al.’s results is $0.18m, $0.2m, and $0.19m when the
initial copper price was $0.8/lb, $0.9/lb, and $1.0/lb, respectively. Since
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the reopening cost is $0.2m, then according to Tsekrekos et al.’s results, it

is optimal to reopen the closed mine if the initial copper price is between
$0.8/lb and $0.9/lb and it is not optimal to reopen it if the initial copper
price is $1.0/lb. This cyclic nature of the optimality contradicts with the
theory of asset pricing in which the optimal exercising policy is linear in
the asset price and there is no any evidence in the literature supports the
hypothesis that the optimality can be cyclic in the asset price. According to
the option pricing theory, if the option to reopen the mine is in-the-money
when the initial copper price is $0.9/lb, it should be also in-the-money at
an initial copper price of $1/lb. The valuation results of Tsekrekos et al.
do not meet this condition. Different from the results of Tsekrekos et al.,
our results meet this condition. Looking at the second column in Table 4,
the difference between the values of the open and the closed mine equals
$0.2m (the switching cost) when the copper price is $0.8/lb or higher. This
indicates that, taking a price interval of 0.1, the option to reopen the mine
is in the money for all copper prices greater than or equals $0.8/lb. These
results are consistent with both the finite difference results and the asset
pricing theory.
In summary, the main difference between Tsekrekos et al.’s results and
our results is in the estimated switching prices. First, the threshold price
to reopen the mine estimated by Tsekrekos et al. (between $0.8/lb and
$0.9/lb) is higher than that estimated in this article and that of Brennan
and Schwartz (1985). Second, different from our results and the results
of Brennan and Schwartz, the option to reopen the mine according to the
results of Tsekrekos et al. is not in the money when the copper price is
higher than $0.9/lb. Although both Tsekrekos et al.’s article and our article
apply the same real options valuation technique, there is a difference in
the estimated prices for exercising the reopening option. This difference
can be attributed to the simulation parameters affecting the accuracy of the
applied valuation technique.
The third attempt was carried out by Gamba (2003) in which he extended
the LSM method to value a hypothetical copper mine differs from that
 152 S.A.A. Sabour and R. Poulin

Table 5. The results of Gamba (2003)

Mine value, $m (Lattice method) Mine value, $m (LSM method)
Initial copper
price, $/lb Open Closed Difference Open Closed Difference

0.75 14.53* 14.83 −0.30 14.23* 14.76 −0.53

0.80 17.41 17.60 −0.19 17.13 17.38 −0.25
0.85 20.47 20.51 −0.04 19.96 19.95 0.01
0.90 23.65 23.53 0.12 22.97 22.71 0.26
0.95 26.91 26.67 0.24 26.11 25.90 0.21
1.00 30.22 29.92** 0.30 29.34 29.03** 0.31
1.05 33.57 33.27** 0.30 32.61 32.33 0.28
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*Optimal to close, **Optimal to open.

presented in Brennan and Schwartz (1985). As reported in Gamba (2003),

the management has the options to shutdown the mine at a cost of $300,000
in addition to an annual maintenance cost of $400,000 during the closing
period. Also, the management can reopen the mine at a reopening cost of
$300,000 or abandon it at no cost. The LSM valuation results of Gamba are
listed in Table 5 at different initial copper prices. Unfortunately, because
there are some missing data, we are not able to rework the example of
Gamba using our extended LSM method. However, we will evaluate the
results of the LSM valuation of Gamba using the results of lattice method
valuation provided also by Gamba for the same hypothetical mine. The last
column of Table 5 shows the difference between the values of the open
and the closed mine. Different from the results of lattice method, it is clear
that the results of the LSM obtained by Gamba indicate that the difference
between the values of the open and the closed mine is cyclic in the copper
price, instead of being linear. For example, since the switching cost for
reopening the closed mine is $0.3m, then based on the difference between
the values of the open and the closed mine listed in Table 5, the threshold
copper price to reopen the closed mine is between $0.95/lb and $1.0/lb.
At a copper price of $1.05/lb, the difference between the two values is
$0.28m indicating that it is not optimal to reopen the mine at this copper
price. Therefore, it could be concluded that the treatment of Gamba (2003)
has the same drawback as that of Tsekrekos et al. (2003) and both lead to
confusing switching decisions.
Based on these comparisons, it is clear that although the previous three
attempts to apply Monte Carlo simulation method for valuing natural re-
source projects have generated satisfactory valuation results, they failed to
determine accurately the threshold prices to change the project status. In ad-
dition to the accurate valuation results for the copper property over a range
of initial copper prices and differently from the results of the previous work,
 Valuing Real Capital Investments 153

our implementation of the LSM method has generated threshold prices for
switching the mine mode that are very close to those of the finite difference
technique. The difference in the valuation results can be owed to some tech-
nical and computational factors. The technical factor affecting the quality
of valuation results includes the rules and conditions set to control the
transition from one operating mode to the other. The computational factor
includes the parameters used in the simulation process such as the number of
sample paths generated and the length of each time step set to approximate
the continuous early exercise feature of American options. If the switching
policy is appropriately implemented, a sufficiently large number of simu-
lation paths are generated and the length of each time step is set as small as
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possible, the differences between the valuation results will be negligible.

Valuing a Multi-Metal Mine

As argued by Barraquand and Martineau (1995), Grant et al. (1997), and

Longstaff and Schwartz (2001), it is very difficult to apply either the fi-
nite difference or the lattice methods for high dimensional problems be-
cause both techniques become impractical in situations where there are
multiple uncertain variables. In contrast, the LSM method can be easily ap-
plied in the cases of multiple state variables and can handle more complex
stochastic processes. In this section, the LSM method is applied to value
a multi-metal mine. The mine data, listed in Table 6, are slightly modified
from the data of a real mining property at the province of Quebec, Canada.
The capital costs, in $m, to be incurred throughout the mine life are 4, 10,
9.7, 3.4, 0.4, and 0.7 at years 0, 1, 2, 3, 4, and 5, respectively. The mine
produces nickel, copper, cobalt, gold, silver, platinum, and palladium. The
symbol α represents the expected annual increase in the metal price, σ is
the annual standard deviation, η is the speed at which the metal price reverts
back to its long-term equilibrium level, S̄ is long-term equilibrium price,
S0 is the initial price at time 0 (end of year 2005), and ρ is the correlation
coefficient between the metal price and the stock market. The prices of
nickel, copper, and cobalt are expressed in $/lb where the prices of gold,
silver, platinum, and palladium are in $/oz.
Different from the simple copper mine presented in the previous sec-
tion, the mine produces seven metals, which means that there are seven
uncertain variables affecting the mine value. Having such irregular cap-
ital spending plan and seven uncertain state variables, it is very diffi-
cult to apply any technique other than the LSM to value the mine with
the real options approach. As a simplification in the case of multi-metal
mines, some valuators used to express all metals in the form of one metal-
equivalent and treat the mine as if it produces only one commodity. This
 154 S.A.A. Sabour and R. Poulin

Table 6. Given data of a multi-metal mine

Metal prices data
Mine data α (%/year) σ (%/year) η S̄ S0 ρ

Tonnage (Q), ton 1.2 million Ni — 32 0.22 3.25 6.25 0.13

tonnes
Production rate (q) 150,000 Cu — 25 0.27 0.87 1.3 0.13
ton/year
Starting production Mid 2006 Co — 40 0.4 6 13 0.17
Average unit operating 150 Au 4.3 20 — — 400 0.16
cost (a), $/ton
Shutting cost, Cc $0.4m Ag 1.4 16 — — 6 0.31
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Reopening cost, Co $0.4m Pt — 27 0.12 400 600 0.06

Maintenance cost, Cm $0.6m/year Pd 12 41 — — 200 0.34
Ni grade, % 2 Taxes:
Cu grade, % 1 Real estate, t3 = 0%/year
Co grade, % 0.05 Income, t2 = 40.0%
Au grade, g/ton 0.5 Royalty, t1 = 0%
Ag grade, g/ton 4 Interest rate, r = 5%/year
Pt grade, g/ton 0.6 Cost inflation rate = 3%/year
Pd grade, g/ton 1.5 Market price of risk = 0. 5

implicitly assumes that all the metal prices follow the same stochastic
process with the exact parameters and the exact correlation coefficients
with the stock market. Since this assumption does not hold, then ex-
pressing all metals in one metal-equivalent can lead to wrong valuation
results.
For valuing the multi-metal mine using the LSM, it is assumed that
the prices of gold, silver, and palladium follow the stochastic process in
Equation (4) while the prices of nickel, copper, cobalt, and platinum follow
the mean-reverting process, proposed by Schwartz (1997), such as:

d S = η (µ − ln S) Sdt + σ Sdz (7)

where η is the reversion speed, µ is the logarithm of the equilibrium price S̄,
and the other symbols are as defined before. The parameters of the stochas-
tic processes for each metal are listed in Table 6 along with the correlation
coefficient with the market. The risk-adjusted prices are determined by
subtracting the risk premium of each metal from the drift of its stochastic
process. The risk premium of each metal is the product of its standard de-
viation, its correlation coefficient with the market and the market price of
risk.
The valuation process is carried out as described before. Table 7 lists
the simulation and regression parameters used in valuing the multi-metal
 Valuing Real Capital Investments 155

Table 7. Simulation and regression parameters of the

multi-metal mine
Item Description

Number of time steps per year 10

Number of simulations 25,000
Regressors The first five terms of the power series
Variance reduction technique The moment matching method

mine. At each decision time, the manager can choose to change the operat-
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ing mode (open/closed) of the mine and pay the $0.4m switching cost, or
abandon the mine early at no cost, since the abandonment cost is assumed
to be zero. During the shutting period a maintenance cost of $0.6m will be
incurred annually. The valuation process is carried out recursively, deter-
mining the optimum operating mode at each decision date and revising the
cash flows in accordance. The mine value is then determined by discount-
ing the cash flows at the risk-free rate and averaging over the number of
paths. The mine value with the operating flexibilities to shut down the mine
temporarily and abandon it early has been found to be $14.82m. When con-
sidering the option to abandon only, the mine value is estimated at $13.81m.
The estimated mine value without any kind of operating flexibilities (i.e.,
with the classical net present value method) is $9.27m. This indicates that
the value of the option to abandon the mine early equals $4.54m (49%
of the net present value estimated without the operating flexibilities), while
the value of the option to shutdown the mine temporarily equals $1.01m
(11% of the net present value estimate).
Now it is important to examine the reasonability of the LSM method
in valuing the operating flexibility of multi-metal mines. Two tests are
performed to ensure that the value of the operating flexibility obtained by
the LSM is reasonable in the real company’s context. First, a company is
willing to quantify the value of the operating flexibility when it is uncertain
about the outcomes of future metal prices. If the company knows certainly
the future prices, it would use the traditional NPV method to evaluate its
project since there would be no need to use a more advanced technique such
as the real options. This implies that, in the context of the real industry, there
is a direct relationship between the level of uncertainty and the value of
the operating flexibility. Now let us see how does this work with the LSM.
Figure 1 shows the value of the operating flexibility, which is the difference
between the real options value and the NPV, at different percentages of the
actual values of the standard deviations listed in Table 6. It is obvious that
as the level of uncertainty increases, the value of the operating flexibility
increases. When the level of uncertainty is very low, which implies that the
 156 S.A.A. Sabour and R. Poulin
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Figure 1. The relationship between the value of the operating flexibility

and the level of uncertainty.1

future prices are certainly known, the operating flexibility has no value.
This is exactly consistent with the real industry thought and experience
related to the issue of the operating flexibility and its relation to the level
of uncertainty. It is worth noting that the value of the operating flexibility
shows a fast decay as the level of uncertainty decreases due to the existence
of the shutting cost, the reopening cost and the maintenance cost to be
incurred during the shutt-down period.
The second test is related to the level of initial metal prices (current prices
at the evaluation stage) and its effect on the management attitude toward
quantifying the value of the operating flexibility. In practice, if the initial
metal prices are sufficiently high to make a real profit margin, the company
usually does not give much attention to evaluate the possibility of shutting
down or abandon its project. In contrary, when the profit margin is small,
the company will have to evaluate its production policy and its available
alternatives to avoid possible future losses if the prices are decreased. This
indicates that the real industry valuates the operating flexibility as small in
case of higher prices and as high in case of lower prices. To examine how

1 The calculations used in plotting Figures 1 and 2 are carried out using 4 time steps per year,

20,000 simulations, the first five terms of the power series as basis functions, and the moment
matching method as a variance reduction technique.
 Valuing Real Capital Investments 157
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Figure 2. The relationship between the value of the operating flexibility

and the level of initial metal prices.

the valuation results of the LSM are consistent with this practical judgment,
the value of the operating flexibility is estimated at different levels of the
initial metal prices (% of S0 ). As shown in Figure 2, as the initial prices
level increases the value of the operating flexibility decreases. This result
agrees with both the practical experience and the scientific interpretation.
If the initial prices are high, the probability that they will fall sufficiently to
produce a negative operating profit decreases, the probability that the mine
will be closed or abandoned decreases and consequently the value of the
operating flexibility decreases. In case of low initial prices, the probability
that the mine will be closed or abandoned increases, and accordingly the
value of the operating flexibility increases.

CONCLUSIONS

The simplicity of simulation techniques can encourage decision-makers to

apply the ROA in their regular investment decisions. In this respect, the
recently developed LSM method can provide a simple and practical tool to
decision-makers. Compared to the other real options valuation techniques,
the LSM method does not require advanced mathematical skills and has the
additional advantage of being able to handle easily multiple and complex
stochastic processes simultaneously. This article showed that the LSM can
 158 S.A.A. Sabour and R. Poulin

be extended to value real capital investments. Based on the results of the

copper mine example provided in this paper, it can be concluded that the
LSM can do the same job as the more sophisticated real options valuation
techniques such as finite difference. If implemented properly, the method
can accurately estimate the value of projects with multiple interacting op-
tions as well as the accurate threshold conditions to switch among the
different operating modes.
As an example for the possible extensions of the LSM method to handle
the cases of multiple sources of uncertainty, the method has been applied
to value a real multi-metal mine with seven uncertain metal prices. It has
been found that the values of the operating flexibilities to shutdown the
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mine temporarily during low price periods and abandon it are 11 and 49%,
respectively, of the classical NPV estimate. Consistent with the real industry
experiences, the value of the operating flexibility has been found to be
growing directly with the level of uncertainty and inversely with the level
of initial metal prices.

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BIOGRAPHICAL SKETCHES

DR. SABRY A. ABDEL SABOUR is the lecturer of mineral economics at Mining and Met-
allurgical Engineering Department, Faculty of Engineering, Assiut University, Egypt
(sabrysabour@yahoo.com; sabry.abdel-hafez.1@ulaval.ca). In September 2000 he obtained
his Ph.D. in mineral economics. His research focuses on applying the real options approach
for evaluating natural resource investments. He is currently a visiting scholar at Université
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Laval since August 2004.

DR. RICHARD POULIN is the professor of mineral economics at Université Laval, Québec City,
Canada (Richard.Poulin@vrex.ulaval.ca; richard.poulin@fsg.ulaval.ca). He holds a Ph.D.
from McGill University. He has been a professor at the University of British Columbia
and previously worked in engineering for 12 years. His main research topics are mineral
resource valuation by real options and risk associated with environmental bonding.