Real Options Analysis of Mining Projects

When long life assets are being evaluated based on constant predictions of future variables and the assumptions of zero management flexibility, is value being missed? In project evaluation today, the most common evaluation methods that calculate a net present value are discounted cash flow (DCF) analysis, decision tree analysis and Monte Carlo simulation. A fourth method, which is beginning to gain ground in terms of its use in the mining industry, is real option analysis (ROA). ROA utilizes a stochastic process and expected asset volatility to more sophisticatedly allocate investment risk at the source, as opposed to the aggregate period cash flows as in more traditional models. The purpose of this paper will be to review the evaluation models currently used in the mining industry and to understand their differences, going in-depth into the use of ROA to understand its advantages and limitations. A mining project is evaluated using the applications of DCF analysis and ROA for the purpose of comparing the results of the more traditional valuation method and one which values uncertainty in a more advanced manner. The paper concludes with the advantages that ROA can provide to management decision making and outlines when the use of ROA is most beneficial.