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REAL OPTIONS VALUATION OF THE LICENSE OF A COPPER MINE

Conference Paper · June 2011

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REAL OPTIONS VALUATION OF THE LICENSE OF A COPPER MINE

Presented at FFM 2011. (Revised September 2013)

Mariano Méndez Suárez

mariano.mendez@esic.edu
ESIC Business and Marketing School, Madrid, Spain.

ABSTRACT

The objective of this paper is to value as a Real Option the License of a copper mine in the exploration
stage.
We conceive the License of a copper mine, as the value of a call option that gives us the right to invest in
the next stage. The underlying asset is the Net Present Value (NPV) of the cash flows of the mine
adjusted by the probability of success. The strike price is the investment required for acquiring the
phase.
For the simulation of the project and the calculation of the volatility of the Real Option using the
Copeland and Antikarov methodology, the copper price, fundamental market risk of the project, is
modeled using a mean reversion with jumps model. Other alternatives of volatility estimation are
discussed.
The valuation of the Real Option is made using a binomial lattice which allows introducing in the process
the subjective probabilities of success from exploration to production.
Keywords:
Real Options with Market and Private Risks, Compound Real Options, Mine Valuation, Binomial Lattices,
Project Volatility Estimation, Mean Reverting Processes
INTRODUCTION

Real option valuation only applies when analyzing projects with 3 characteristics:

There is a space in time between the investment decision and the investment outlay. If this distance in
time does not exist, the rule of valuation is equal to the Net Present Value (NPV).

There exist a sequential investment in which is possible the managerial intervention in order to modify
the project outcome.

The present value of Cash Flows is subject to volatility until the final decision of investment.

Borison (2005) makes a clear classification of the Real Option different valuation approaches:

Classical replicating portfolio assumption:

Represented by Amram and Kulatilaka (1999) Brennan and Schwartz (1985), Trigeorgis and Mason
(1987) and Trigeorgis (1999).

In this approach all the necessary information for the Real Options valuation comes from the market
data of a traded replicating portfolio. Once the asset has been identified the financial options
methodology is applied.

Various alternative solutions are used to estimate the key assumption that is volatility:

Using the volatility of the return of a similar traded company. This approximation might lead to error,
because finding a company whose characteristics exactly would be very difficult.

Using the volatility of those elements that generate the project’s cash flows, such as, for instance, the
volatility of electric power prices; however, these elements only partially reflect the project’s
uncertainty. Usually the volatility of the project is different from the volatility of the components of its
income, due to reasons as impact of the factor in the result, or inverse correlation between its factors.

The Marketed Asset Disclaimer (MAD assumption) equilibrium based subjective data of Copeland and
Antikarov (2001):

The first assumption is that in the absence of an effective method of estimating the volatility of a project
with no reflection in the market, the project itself is used by assuming that the project’s market value is
its present value, this way we can and assess volatility by simulating its expected returns from year 0 to
year 1 by combining all market uncertainties into a single one: the volatility of the project.

The second assumption of Copeland and Antikarov is that assets follow geometric Brownian motion and
the binomial lattice can be used to valuation.
The methodology of Copeland and Antikarov (CA) is very well documented in their book (2001),
chapters 9 to 11, and is also very clearly explained in Brandao et al (2005).

Combination of market and private risks.

The introduction of private risk represented with success/failure probabilities, is suggested in the Real
Option valuation introduced by Smith and Nau (1995) and Smith and McCardle (1998). We use the
technique used in binomial lattices by Villiger and Bogdan (2005).

The idea of Smith and Nau is to use option pricing method to value the market risks of the project and
decision analysis procedures to value the private or non market risks. Using a decision tree adjusted by
risk may be very complicated because of the different risk that can appear in each stage of the
investment process, the Villiger and Bogdan technique solves this problem by using binomial lattice to
cope with market risk and probability estimation to cope with private risks.

MEAN REVERSION SIMULATION OF PRICES

Mean reversion models originally proposed by (Uhlenbeck & Ornstein 1930) are predicated on the
notion that the long‐term behavior of prices gravitates towards a mean price.

The price adjustment mechanism is accounted for by market forces, in that –leaving aside speculative
movements in financial markets, which in specific cases can be the cause of price volatility‐ the market
adjusts itself in periods of strong demand and rising prices through an increase in the offer, e.g. by
opening up closed mines, by extending the life span of mines scheduled to be shut down, etc. Following
this increase in the offer, prices tend to fall. In periods when prices are low, the opposite occurs, so that
the offer decreases and prices tend to go up.

(Dixit & Pindyck 1994) suggest the use of the mean reversion model to model the behavior of
commodity prices and propose a model that will be used in the paper.

The model of Poisson jumps for the securities prices was proposed by (Press 1967). (Merton 1976)
proposes a model of geometric Brownian motion with jumps which characterizes the jumps as the
arriving of new important information. Merton makes an important improvement to the model
adjusting the Poisson process to convert it to a Martingale.

(Das 1998) uses a model of mean reversion with exponentially distributed Bernoulli Poisson jumps for
modeling interest rates developing an analytical formula for the parameterization of the model.

(Dias & Rocha 2001) applies the (Dixit & Pindyck 1994) model with Gaussian distributed Poisson jumps
for modeling petroleum prices. The important contribution of (Dias & Rocha 2001) is the specification of
the discrete model for the simulation although they make a simplification because they apply the same
probability of jumps up or down using a Gaussian distribution for the size of the jump.
In our case we will use the (Dixit & Pindyck 1994) model adapted by Dias & Rocha, but deriving
ourselves the discrete simulation formula of the Poisson jumps.

MODELING MEAN REVERSION

A given random variable, XT, responds to the following stochastic differential equation:

dx    x  x  dt   dz

With x being the expected mean price, x the current price, and  a reversion speed parameter that

will be explained below.

The formula tells us that dx tends to be negative when x  x ‐that is, when the mean price is smaller
than the current price‐, thus meaning that the change tends to push prices down. However, when x  x
, the mean price is higher than the current price, and dx tends to represent a positive change that
pushes the price upward.

The speed of reversion is given by parameter , a reversion process’s mean life is the time it takes for
the price to cover half the distance that separates it from the mean price. In other words, a mean life of
one year means that it takes two years for the price to reach its mean value.

The relationship between mean life, H, and reversion speed, , is:

log  2  log  2 
H ; 
 H

The solution of (Kloeden & Platen 1992) for the previous stochastic differential equation in terms of Ito’s
stochastic integral is as follows:

xT  x0 e T  1  e T  x   e T  e t dz

T

As pointed out by (Dixit & Pindyck 1994), the mean and the variance of the XT variable are given by the
following expressions:

E  X T   x0 e T  x 1  e T 
2
Var  X T   1  e 2 
2

Since XT follows a distribution which may take negative values, we will define x  log( S ) and S  e x ,

with S being the asset price.

The variance needs to be adjusted by ½ in order to obtain the exact formula for the simulation, which
will thus be:

 2t 
 log  St 1  et  log  S  1 et  1 e2t   1 e
  
2
dz 
 4 2 
St  e  

dz N  0,1

where the first two terms on the right‐hand side are the process’s drift terms that weigh the initial value
and the mean value of equilibrium. The third term is an adjustment term required by Jensen’s
inequality, and the fourth term is the variance term multiplied by a Wiener stochastic process that
draws values from a N (0,1) distribution.

MEAN REVERSION MODEL WITH POISSON JUMPS

Mathematically, a mean reversion process with jumps is formulated by adding a new term to the mean
reversion’s stochastic differential equation:

dx    x  x  dt   dz  dq

The dq term is a Poisson term whose value is zero most of the time; yet  often takes a value that
prompts a jump in the variable x  log( S ) .

0 with probability 1   dt
dq 
1 with probability  dt

Should there be up jumps with a frequency u and down jumps with a frequency d, then:

  u  d

So that dq is the jump‐size distribution when such jumps are up or down ( u , d ).

We start from the assumption that the mean reverting process, dz, and the Poisson process, dq, are not
correlated.

The jump’s size and direction are random, and k  E   is the expected value of the joint distribution

() for up jumps and down jumps.

In order for the expected value of the dx process to be independent of the jump parameters, it needs
to be compensated by subtracting from it the term k. We thus use a compensated Poisson process and
eliminate the trend that might incorporate into the process the effect of a higher number of up or down
jumps. Hence, the modified formula is:
dx    x  x    k  dt   dz  dq

The mean of XT now becomes:

E  X T   xe   x   k  1  e 

Note that when the expectation of the jumps is k = 0, this last expression is identical to the expectation
of XT in a mean reversion process without jumps, confirming that the possible trend introduced by the
jumps has indeed been eliminated.

The variance of the mean reversion process with jumps is:

 2  Var  
Var  X T  
2
1  e2 

We adjust the solution of the process by including the variance term of the Poisson distribution for up
and down jumps:

 log  St 1  et 
 


 log  S  k  1  e 
t


  dq  1 e2t    u  d Var   
2

   4 
 2t 
 1 e 
  
dz 
St  e  
2

For the simulation of the St variable, which follows a mean reversion process with jumps, we use the
following formulas:

xt  log  St 1  e t
 log  S   k  1  e t 

1  e 2t
 dz  dq
2

and:

  2  Var   
 
 xt  1 e 2t 4


St  e  

  u  d is the sum of the frequencies of up jumps and down jumps, respectively, and Var   is the

variance of the jump process that we will be obtained directly from the market data.
To simulate the occurrence of a jump, the expected frequency of up jumps and down jumps per time
unit is compared, for each period, with a random value obtained from a [0,1] uniform distribution. If the
value drawn in the random extraction is u  u dt , then a jump up is assumed, and dq takes its value. If,

on the contrary, u  d dt , then a jump down is assumed, and dq takes its value.

CALCULATING THE MEAN REVERSION PARAMETERS

(Dixit & Pindyck 1994) described how to estimate the mean reversion parameters, building on the idea
that the mean reversion’s partial differential equation

dx    x  x  dt   dz

matches the following AR (1) discrete‐time autoregressive process:

xt  xt 1  x 1  e    e  1 xt 1   t

Where  t follows a normal distribution with standard deviation   , and:

2
 2 
2
1  e2 

Hence, the parameters of the AR(1) equation may be estimated using market price data by means of the
following regression:

xt  xt 1  a  bxt 1   t

Which allows us to determine the mean reversion parameters:

aˆ
x ,
bˆ

ˆ   log 1  bˆ 
THE DATA

In the Graph 1 Copper prices London Metal Exchange. Dotted line from January 1996 to July

2004. Solid line from July 2004 to April 2011. we can see the copper prices from January 2006 to
April 2011. The sample selected for the analysis of prices is from July 2004, moment in which we
observe a price similar to the minimum of December of 2008, until April 2011.
 500

450

400

350

300

250

200

150

100

50

0
1013
1105
1197
1289
1381
1473
1565
1657
1749
1841
1933
2025
2117
2209
2301
2393
2485
2577
2669
2761
2853
2945
3037
3129
3221
3313
3405
3497
3589
3681
3773
93
185
277
369
461
553
645
737
829
921
1

Graph 1 Copper prices London Metal Exchange. Dotted line from January 1996 to July 2004. Solid
line from July 2004 to April 2011.

In order to model the series as a mean reverting process we must reject the hypothesis that the series is
a random walk. A random walk is not stationary in mean and has a variance that growth with time and is
modeled as a Geometric Brownian Motion. If the series is not a random walk it can be modeled as a
mean reverting process that is stationary in mean and the variance do not growth with time.

Unit Root Test measures stationarity in mean. The null hypothesis is that the coefficients of the
regression of the variation of prices and the first lag are 0. If it is significantly different from 0 we may
assume a mean reversion process.

On the other hand Variance Ratio Test analyzes the ratio between the expected variance growth that is
dependent on time in the Random walk and the evolution of the variance of the series. If the series is a
random walk this ratio should be 1.

Mean reversion parameters estimation

We use the log of the prices series to estimate the regression parameters aˆ  0.012955214 ,

bˆ  -0,002205 and   0.021238879 , using these parameters to determine the reversion values given by
Dixit and Pindyck’s formula, and we arrive to the results of Table 1.

x  5.876; P  356.43
ˆ  0.01503; ˆ  0.002207
Half Life = 314.04 days
Half Life = 1.24 years

Table 1. Mean reversion parameters.

We obtain a mean price of 356.43 ç/pound. The estimated half life of 314.04 days corresponds to a half
life of 1.24 years entails that the series goes back to its mean approximately every 2.5 years.
As for the standard deviation, we notice that it tends to 0.015035, which corresponds to a 23.86%
annual standard deviation.

Estimating the jump distribution

We will estimate the parameters of the jump distribution on the basis of (Clewlow & Strickland’s 2000)
work considering that values of more than 3 standard deviation are jumps in the series.

In order to isolate the jump component, we subject the returns to a recurrent filtering. The
methodology is as follows:

1. We analyze the series and take out the returns located above or below the 3 standard
deviation limits.
2. We analyze the series again and similarly take out the returns above or below 3 standard
deviations.
3. We keep on doing this until there are no more returns left above or below the 3 standard
deviation limits.

This way we obtain three different series, the first one with the up jumps, the second one with the down
jumps, and the third the filtered returns.

Parametrizing the jumps

The outcome of the filtering iteration reveals that there are a total of 10 up jumps and 13 down jumps.
These results allow us to obtain the frequency and distribution of the up and down jump functions.

The up jumps’ expected frequency is 10 jumps every 1702 days ‐i.e. a frequency of 0.588%. The down
jumps’ expected frequency is 13 jumps every 1702 days ‐i.e. a frequency of 0.764%.

The overall frequency is 23 jumps every 1702 days ‐that is, a frequency of 1.352%, more than double of
the expected 0.54% of data in excess in the 3 standard deviation of the normal distribution.

In order to characterize the jump probability function, the data gathered from both the sample of up
jumps and the sample of down jumps and its probabilities are introduced into the simulation program.
 Up Jump Probability Down Jump Probability
0,062681 10,0% -0,062016 7,7%
0,062815 10,0% -0,067095 7,7%
0,066206 10,0% -0,068795 7,7%
0,066235 10,0% -0,069445 7,7%
0,068196 10,0% -0,070487 7,7%
0,068206 10,0% -0,072578 7,7%
0,071719 10,0% -0,077312 7,7%
0,072806 10,0% -0,080377 7,7%
0,099088 10,0% -0,080645 7,7%
0,113530 10,0% -0,081751 7,7%
-0,082389 7,7%
-0,096774 7,7%
-0,118370 7,7%

Table 2. Up and down probabilities functions.

Simulating the mean reversion motion with jumps

We use the above‐stated formulas to simulate the mean reversion process with the preceding
parameters

Copper price simulation 2011 to 2020 ç/pound

550

500

450

400

350

300

250

200
Year: 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
=Mean,+1/-1SD =95%,5%

Chart 1. Graphical output of 1000 simulations of the mean reversion with jumps model.

THE PROJECT AS A REAL OPTION

A mining project basically consists in the estimation of the quantity of mineral in a certain zone, the
possibilities of extraction, and its economic feasibility.

The investment is sequential and each step may be treated and evaluated as independent. The idea is to
invest only in the next step if we consider that the net present value of the project in each decision is
greater than the investment needed.
The five basic steps are:

 Exploration
 Profile engineering
 Conceptual engineering
 Basic engineering
 Production

The exploration phase has been completed and we have obtained the most important information for
developing the economic valuation.

Total Quantity of Mineral: 3.8 million tons

Speed of extraction:
Duration of the extraction:
Mineral law:
Recuperation:
Law of the concentrate:
1.8 thousand tons per day
6 years
Normal N(2.5;0.6)
Triangular T(0.85;0.87;0.9)
Lognormal L(0.32;0.02)

The mineral law is the estimated percentage of copper in the gross mineral; it has been estimated to
correspond to a normal distribution with mean 2.5% and standard deviation of 0.6%. We expect to
obtain at a 99% confidence level between 0.7% and 4.3% metal from the mineral.

From this metal we can only extract a percentage which has been estimated to follow a triangular
distribution with an expected value of 87%, a minimum value of 85% and a maximum value of 90%.

The extracted mineral forms a concentrate that is not pure; it contains a quantity of mineral that is
indicated from the law of the concentrate. This law follows a lognormal distribution with parameters:
mean 32% and 2% standard deviation.

The rest of the steps are shown in the chronogram, which includes the time to completion, the
probability of success based on the experience, the cost of the phase in thousand dollars and the
percentage of the cost of each phase respect to the total costs.

2011 2012 2013 2014 2015 Prob. Cost Phase % Investment

Quarters Q. 1 Q. 2 Q. 3 Q. 4 Q. 1 Q. 2 Q. 3 Q. 4 Q. 1 Q. 2 Q. 3 Q. 4 Q. 1 Q. 2 Q. 3 Q. 4 Q. 1 Success KUS$ per Phase
Profile Engineering 50% 309 1%
Conceptual Engineering 70% 618 2%
Basic Engineering 90% 3,708 12%
Production 100% 26,262 85%

In each phase, the evolution of the market i. e. the price of copper, or the results of the different
engineering can force abandonment of the project. Therefore, we have to adjust the cash flows with
their probability of occurrence, derived from the statistical success rates of the different engineering
phases.
It can be seen that the probability of success increases as we invest in the project and the cost of each
stage increases.

From the point of view of the risk, at the beginning of the project we have both private or probability
measurable risks and market risk. When the mine is in production we only have market risk.

We will invest $309,000 in the first quarter of 2011 if the net present value of the project is greater than
this cost. We will invest $618,000 in the first quarter of 2012 if the net present value of the project is
bigger than the investment and so on, until the final investment of 26.2 million dollars in the first
quarter of 2015.

The idea is that with each investment we buy the right but not the obligation to invest in the next stage.

In financial options terminology in each phase we compare the cost of the investment “K” or “Strike
price” with the value of the underlying asset “S” (present value of the future cash flows of the mine) and
the value of the option is:

Option value = max (Present Value of the Mine (S) – Investment (K); 0)

This decision rule is the same as the rule of a European Call Option.

NET PRESENT VALUE (NPV)

The weighted average cost of capital (wacc) estimated for the project is wacc = 12%. The NPV and the
cost of each phase of the project are in the Table 3. This NPV do not takes into account the
success/failure probabilities nor the managerial flexibility

KUS$ Qr. 1 - 2011 Qr. 1 - 2012 Qr. 1 - 2013 Qr. 1 - 2015

Quarters 0 4 8 16
Profile Engineering -309
Conceptual Engineering -548 -618
Basic Engineering -2,917 -3,288 -3,708
Production -16,251 -18,323 -20,659 -26,263
Total Investment 2011 -20,025 Investment 2015 -26,263
Present Value of Cash Flows 2011 139,581 PV of Cash Flows 2015 225,573
NPV 2011 119,556 NPV 2015 199,311

Table 3. NPV of the project

BINOMIAL METHOD FOR THE VALUATION OF COMPOUND OPTIONS WITH PRIVATE RISKS

The binomial method developed by CRR (1979) is based on the non‐arbitrage theory, thereby obtaining
a series of parameters for the evolution of the asset value and its risk‐neutral probabilities.
The model is built on the idea that the value of asset changes over time, either increasing or decreasing.
In a non‐arbitrage environment, this value change is independent of the return on the asset because the
market risk is implicit in the asset volatility and that it’s up and down factor depends solely on the latter.

Parameters representing upward and downward changes in asset value are described by the letters u
and d, and their respective formulas are as follows:

1
u  e ( t )
; d
u

with  being the annual standard deviation of asset returns, and t the time change from one period to
the next.

Risk‐neutral probabilities of an increase (u) or a decrease (d) in value are represented by p and q:

(1  rf )  d
p ; q  1 p
ud

with rf being the return on the risk‐free asset.

The future value of the asset in Vu and Vd are weighed with their associated risk neutral probabilities and
discounted at the risk‐free rate, obtaining the value of the asset at time 0 V0:

Vu p  Vd (1  p)
V0 
(1  rf )

The data needed for valuation, are the following:

 The present value of the project’s expected cash flows (PV).

 The expected volatility of the project’s return ().
 The risk‐free interest rate (rf).
 The investment cost of launching the project (I).
 The estimated probability of success for each decision stage (s).
 The cost of intermediate investments (C).

The process involves three stages:

1) Projection of the diffusion process of the asset value on the basis of the upward (u) and downward (d)
changes and discount the values at the risk‐free rate rf:
 PVu PVu 2
t 1  r f  1  r 
f
2

PVud
PVu
1  r 
2
f

PVd PVd 2

  rf
1  1  r 
f
2

2) Comparison of the final value with the investment cost of launching the project (I) and choosing the
highest value between the figure thus obtained and 0 in order to determine the value of the RO in this
node. This way we calculate the expected value of the project using risk‐neutral probabilities.

t t
  
PVu2
Max    I ;0  RO21
RO11  pRO21 qRO22 p  f 
  1 r 2  
  

RO  p  RO11  q RO12 p   
q
Max    I ;0  RO22
PVud

  f 
  1 r 2
 
q p  

RO12  pRO22 qRO23 q   

PVd 2
Max    I  ;0   RO23
  f 
  1 r 2
 
 

3) Application of the maximization rule taking into account the probability of success of each stage:


Max  RO· p  RO·q  ·Probability  PV of stage cost  ; 0 
 The rule selects the maximum value between the project expected value, times the probability
of reaching that state, minus the investment cost and 0. In other words, we will purchase the
next stage of the project solely if the value of this stage multiplied by its probability is higher
than the outlay that we need to make.
 Otherwise we shall abandon the project and, at that point and its value will be reduced to 0.

We thereby obtain the option’s end value, RO*.

t t

 C  
RO11*  Max  sRO11  ;0 RO21
 (1 rf )  
 p

RO *  p  RO11*  q  RO12* p
q
RO22
q p

q
 C   RO23
RO  Max sRO12 
*
;0
12
 (1 rf )  

ESTIMATING THE PROJECT’S VOLATILITY

The CA (2001) method consists of the following steps in order to estimate the volatility of the project:

1) Projection of the cash flows and estimation of the present value of the project at time 0 (PV0),
using the project’s WACC as discount rate.
2) Introduction of the project’s uncertainties. In our case:
a. Mineral law.
b. Recuperation.
c. Law of the concentrate.
d. Copper price.
3) Running a Monte Carlo simulation program to generate the distribution of present values (PV)
at date 0 and date 1. Present value at period 1 includes the expected cash flows (CF1) of that
period.

 PV  CF1 
z  ln  1 
 PV0 

The z value is the return of the project from period 0 to period 1. Is calculated by keeping constant the
project’s present value at 0 (PV0) and simulating the variables of the model of the present value at date
1:

n
CFt
PV1  
t 2 (1  WACC )t 1

The standard deviation of the distribution of returns from date 0 to date 1 will be the estimated
volatility of the project. Since we assume that the value of the project (PV) follows a lognormal
distribution with constant volatility, we use that same volatility figure throughout the project life.

REAL OPTIONS CALCULATION

The parameters for the Real Options calculation are the following:

The annual volatility of the returns of the mine in our case is  = 28.24%.

In quarterly terms:

 qr .  28.24% 0.25  14.12%

And the binomial lattice parameters:

 u= 1,15
d= 0,87
p= 50,92%
q= 49,08%

The first value of the binomial lattice is the present value of the project of $139.5 million in 2011, the u
and d parameters are applied.

Quarter 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
KUS$ 139,581 160,747 185,124 213,196 245,526 282,758 325,636 375,016 431,884 497,376 572,799 659,659 759,692 874,893 1,007,563 1,160,353 1,336,311
121,202 139,581 160,747 185,124 213,196 245,526 282,758 325,636 375,016 431,884 497,376 572,799 659,659 759,692 874,893 1,007,563
105,243 121,202 139,581 160,747 185,124 213,196 245,526 282,758 325,636 375,016 431,884 497,376 572,799 659,659 759,692
91,385 105,243 121,202 139,581 160,747 185,124 213,196 245,526 282,758 325,636 375,016 431,884 497,376 572,799
79,352 91,385 105,243 121,202 139,581 160,747 185,124 213,196 245,526 282,758 325,636 375,016 431,884
68,903 79,352 91,385 105,243 121,202 139,581 160,747 185,124 213,196 245,526 282,758 325,636
59,830 68,903 79,352 91,385 105,243 121,202 139,581 160,747 185,124 213,196 245,526
51,952 59,830 68,903 79,352 91,385 105,243 121,202 139,581 160,747 185,124
45,111 51,952 59,830 68,903 79,352 91,385 105,243 121,202 139,581
39,171 45,111 51,952 59,830 68,903 79,352 91,385 105,243
34,013 39,171 45,111 51,952 59,830 68,903 79,352
29,535 34,013 39,171 45,111 51,952 59,830
25,646 29,535 34,013 39,171 45,111
22,269 25,646 29,535 34,013
19,337 22,269 25,646
16,790 19,337
14,580

Second we calculate the present value of the project using the risk free rate of rf = 5%.

Quarter 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
PV rf 139,581 158,751 180,553 205,349 233,551 265,626 302,106 343,597 390,785 444,454 505,493 574,916 653,873 743,673 845,806 961,966 1,094,079
119,696 136,135 154,831 176,095 200,279 227,785 259,068 294,647 335,113 381,136 433,480 493,013 560,721 637,728 725,312 824,923
102,644 116,741 132,774 151,008 171,747 195,334 222,161 252,671 287,372 326,839 371,726 422,777 480,840 546,877 621,983
88,021 100,110 113,859 129,495 147,280 167,507 190,511 216,676 246,433 280,277 318,769 362,548 412,339 468,968
75,482 85,848 97,638 111,047 126,298 143,644 163,371 185,808 211,326 240,349 273,357 310,899 353,597
64,728 73,618 83,728 95,227 108,306 123,180 140,097 159,337 181,220 206,108 234,414 266,608
55,507 63,130 71,800 81,661 92,876 105,632 120,139 136,638 155,403 176,746 201,019
47,600 54,137 61,572 70,028 79,645 90,583 103,023 117,172 133,264 151,566
40,818 46,424 52,800 60,051 68,299 77,679 88,347 100,480 114,279
35,003 39,811 45,278 51,496 58,569 66,612 75,761 86,165
30,017 34,139 38,828 44,160 50,225 57,123 64,968
25,741 29,276 33,296 37,869 43,070 48,985
22,074 25,105 28,553 32,474 36,934
18,929 21,529 24,485 27,848
16,232 18,462 20,997
13,920 15,831
11,937

Third, the solution of the Real Option value using the maximization rule.

Quarter 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Phase Profile Engineering Conceptual Engineering Basic Engineering Production
PV Cost -309 0 0 0 -548 0 0 0 -2,917 0 0 0 0 0 0 0 -16,251
Probability 50% 100% 100% 100% 70% 100% 100% 100% 90% 100% 100% 100% 100% 100% 100% 100% 100%
37,245 87,185 100,920 116,542 134,309 221,521 254,353 291,694 334,164 428,203 489,242 558,665 637,622 727,422 829,555 945,715 1,077,828
62,581 72,937 84,716 98,112 162,709 187,464 215,619 247,640 318,862 364,885 417,229 476,762 544,470 621,477 709,061 808,672
51,838 60,719 70,820 118,365 137,030 158,258 182,402 236,420 271,121 310,588 355,475 406,526 464,589 530,626 605,732
42,626 50,241 84,930 99,003 115,009 133,214 174,260 200,425 230,182 264,026 302,518 346,297 396,088 452,717
34,727 59,721 70,332 82,400 96,126 127,393 147,120 169,557 195,075 224,098 257,106 294,648 337,346
40,716 48,714 57,813 68,162 92,055 106,929 123,846 143,086 164,969 189,857 218,163 250,357
32,420 39,275 47,078 65,410 76,625 89,381 103,888 120,387 139,152 160,495 184,768
25,309 31,182 45,321 53,777 63,394 74,332 86,772 100,921 117,013 135,315
19,218 30,176 36,549 43,800 52,048 61,428 72,096 84,229 98,028
18,803 23,566 29,027 35,245 42,318 50,361 59,510 69,914
13,863 17,900 22,577 27,909 33,974 40,872 48,717
9,674 13,049 17,045 21,618 26,819 32,734
6,174 8,904 12,302 16,223 20,683
3,342 5,379 8,234 11,597
1,230 2,416 4,746
0 0
0

CONCLUSIONS
 The Real Option valuation offers a value $37.2 million dollars for the option to invest sequentially in the
project. The valuation, takes into account the different conditions in the market via the volatility of the
project and the expected probabilities of success or failure and reflects the possibility of the managers
of the company to abandon or delay the project just before the launch as is reflected in the bottom
states of the binomial lattice corresponding to quarters 15 and 16.

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